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Executive pay schemes are not fit for purpose

Andrew Smithers, respected City economist, told a High Pay Centre debate that executive pay schemes reward short-term behaviour rather than investment in long-term business success

Executive pay schemes are not fit for purpose and are not doing what they were designed to do, according to respected City economist, Andrew Smithers who was speaking at a High Pay Centre debate today.

“There has been a revolution in the amount and manner in which senior executives are paid,” said Mr Smithers. “There has been a shift from salaries to mainly bonuses – 83 per cent of executive pay in the US is in the form of bonuses – if you change incentives, you change behaviour, that’s what incentives are for.”

Mr Smithers argues that current incentive schemes reward executives for very short-term behaviour aimed at driving up the share price as that is what pushes their pay schemes up. “The risk for management is in not getting their bonuses while they are in office.” Chief executive tenure has shrunk to around 4 years.

This encourages short-term decision-making to boost earnings per share rather than improve productivity and invest in the long-term future of the company. Executives are incentivised to buy their own shares rather than invest in plant and equipment.

“You would expect to see lower business investment and higher profit margins and that is exactly what is happening in the US and the UK,” said Mr Smithers. “US profit margins are at record levels but business investment is extremely depressed in both countries.”

At the same time, share buybacks are running at an “astonishingly high” 2-3 per cent on GDP. Since share buybacks increase a company’s share price, they boost the value of executive share schemes such as Long-Term Incentive Plans which run over three years and involve a payment to executives in shares.

Smithers said investment has surprised people because it’s been so poor and productivity has been very poor in the UK and US. “But the reason for the surprise is the failure to recognise management’s incentives.”

“These incentives are not in the long-term interests of shareholders because companies are under-invested,” Mr Smithers explained. They are also not in the long-term interest of the economy.

Current executive pay schemes were developed to align the interests of the directors with those of shareholders. “It is at the heart of our corporate governance system,” said Janet Williamson, senior policy officer at the TUC, “and this (Smithers’ analysis) drives a coach and horses through the governance system.”

Ms Williamson who also addressed the debate, said that one argument for reform was to change the performance metrics used. “But that would be a mistake, our preferred solution would be to move away from performance-related pay altogether and back to salary as the main component of pay.” “Do we want directors who make decisions based on their pay?”

You can view Mr. Smithers' presentation in the file below, and Andrew Smithers book, Road to Recovery is available from Wiley.com with a 30 per cent discount using the promotion code RTR30.

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Posted on 6 March 2014

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