The dust has settled on “Fat Cat Tuesday”. No good arguments have been offered in defence of excessive pay. What does this tell us?
Common misunderstandings about top pay
– some thoughts from Paul Marsland, deputy director of the High Pay Centre
Tuesday 5th January was the day estimated by the High Pay Centre to be the moment on which typical UK workers’ annual earnings are overtaken by typical FTSE 100 CEO earnings.
As ever the issue of executive pay attracted much public comment, including some which repeated some common misunderstandings about top pay.
Current levels of high pay are neither a product of free market economics nor of interference by well-intentioned regulators. Like all simple solutions to complex questions the following assertions are evidence of under-thinking the issue.
CEOs are worth “a lot” because they make big decisions
To argue that executives are paid “a lot” is to acknowledge that we all place executive pay on our own quantitative scale. Analysis which claims CEOs are worth “a lot” inadvertently hits on precisely why pay multiples are relevant and important.
The claim that executives are paid a lot demands an understanding of what “a lot” means to a company. In fact based on a measure of what is material to financial statements few if any executives are worth “a lot” to a company. This is not to say that companies do not value executives with proven competencies and skills, but for large listed companies a discussion of one person’s pay in the context of how much a company can afford is silly.
Only one company in the FTSE 100 discloses executive pay which is higher than the “threshold for materiality” set by its auditors for the purpose of the audit of group accounts. In fact executive pay could be doubled at 80% of FTSE 100 companies and would still not be a material amount for the purposes of the accounts.
Definitions of what is a lot depend on the scale you are using. There are consequences if everyone with an interest in measuring something doesn’t agree on the scale to be used at the outset. Just ask NASA about the loss of its $125m Mars Orbiter in 1999. The NASA team used metric units whilst the contractor used imperial. Pay awards in the hundreds of thousands of pounds leave the public wondering how such an amount could possibly be justified and leave the City wondering what all the fuss is about.
While companies could afford to double executive pay without it becoming “a lot” they cannot afford to double everyone else’s pay. In fact affordability has been the key concern of large retail businesses following government intervention to force businesses to pay a living wage to their employees. The lack of internal pay comparators allows a situation to persist in which top pay is always affordable at the same time as the affordability of low pay is questioned even when it is legally prescribed.
It is also wrong to over-attribute any value that may be created or destroyed by strategic corporate decision making to a single individual. Crediting a CEO with a decision good or bad panders to the lazy personification of corporate governance. The CEO cult idea ignores the UK’s formal governance system which includes the concept of a unitary board.
Strategically important decisions are matters reserved for the attention of the board. Articles of association contain board voting thresholds for approval of matters reserved for the attention of the board for good reason. The decisions which make or break a company should be board decisions not CEO decisions. All those taking the decision bear the same, now codified, legal duties. In this context the size of the pay package is irrelevant to identifying where the buck stops. Whether the director is a NED on £100k or a CEO on £10m the legal duty is shared.
CEOs are valuable because the share price says so
Value here is being confused with share price volatility. Share price lurches correlate better with the suddenness of the governance change rather than an informed view that crystallises the worth of a particular person. Markets don’t like surprises or uncertainty. Succession planning is a critical part of corporate governance.
The correlation versus causation argument kicks in here too. Is share price really attributable to a single individual? The share price is up so CEO must have created value, right? Wrong. Factors which are exogenous to the influence of an individual manager, the price of oil, for example, or government policy, are far more likely to affect share price.
Value is not synonymous with share price. As evidence of why a CEO is worth a lot one critic claimed £220m of value was created by an announcement at Tesco that the CEO would take on an active management role. It’s worth a closer look at this example. In March 2012 Tesco CEO Philip Clarke made a statement that he would be taking a more hands on role following the departure of Richard Brasher, the long serving boss of the UK business. The CEO created misplaced confidence, not value. During this same period senior Tesco executives were busy inflating trading profits via the manipulation of customer rebates. In September 2014 Tesco announced that it had overstated its forward profit guidance by an estimated £263m. In other words, contrary to the claim that value was being created by the CEO real value was nothing like the value reflected in the share price.
The attribution of a rise or fall in share price to a good or bad CEO belies a misunderstanding about what executives are being paid to do. Managers should be managing the business not managing the share price. At Japanese camera maker Olympus Michael Woodford proved himself to be an exemplary CEO but a disaster for the share price, which collapsed after he did the right thing and exposed concealed investment losses.
Then there is the rather obvious point that value is only value if it is realised or realisable. Shareholders are not homogenous. Full value is there for those selling out at the right time but long term investors like pension funds or index funds are not typically in this position. Claims that a CEO’s value can be measured by the millions wiped off or added to the share price of the company on a given day don’t bear scrutiny. The loss or gain in value is notional.
This difference between notional value and realised value is often made by companies defending allegations of excess based on the face value of a share award. Listed companies vehemently reject the idea that the face value of a conditional award represents what a director is actually paid. Accounting standards applicable to UK listed companies are also premised on the concept that the expense recognised in the accounts for share-based payments should not be the face value. The argument that a short term shift in share price represents a measure of the perceived value of a CEO is tempting, but wrong.
Nothing better than the current system for valuing executive pay
Assuming that critics of the current system cannot point to a better way of valuing executive pay smacks of complacency and assumes the flaws in the current process cannot or should not be addressed. The current model has failed on its own terms. Performance has not been commensurate with pay. Plenty of flaws and remedies are identifiable. To add to well-publicised policy recommendations, such as employees on remuneration committees and publication of pay ratios: open adverts for executive recruitment; judicious use of (and reporting of) discretion by remuneration committees; longer holding periods; introduction of clawback or “malus”; prohibition on incentive buy-outs; better disclosure of fees paid to remuneration consultants; alignment between pay KPIs and KPIs in the strategic report; lower starting levels for new executive recruits than previous incumbent; greater focus on cash; avoidance of multiple incentive schemes; changing fee mechanisms for head-hunters; ensuring executive pay is an HR issue and not just an ESG PR exercise; enforcing current disclosure rules around maximums; and perhaps above all recognition that fundamental change is needed if a look back at successive multiyear share-based incentive schemes shows that pay didn’t match performance.
Pay at one firm has to be comparable with pay at another
The High Pay Centre’s call for disclosure of pay ratios has been criticised on the grounds that “it doesn’t even make sense across firms”. This criticism falls into the trap of assuming there is a single marketplace for CEOs. Why should we assume that pay at Tesco automatically has relevance to pay at QinetiQ? To quote from the High Pay Centre’s recent report on pay ratios: “Lack of adequate human capital reporting is a key factor limiting comparability of company pay ratios.” No two companies are the same. The skill set needed for a business model that relies on being big enough to squeeze suppliers’ margins and shift very high volumes to millions of customers via a range of channels cannot be assumed to be the same as the skill set needed for a business that makes money by selling R&D-dependent defence and security services to a comparatively tiny number of mainly government clients. Steve Wadey, CEO at QinetiQ, is an engineer. Dave Lewis at Tesco has spent nearly 30 years in consumer products businesses. As the business models and the skill sets aren’t necessarily transferable the assumption that the value attached to the CEO of one is critical to the value of the other is misleading. There isn’t a single CEO marketplace.
CEOs are more important than they used to be
Even the fiercest critics of the desire to monitor top pay concede that the unprecedented acceleration of top pay away from median pay in recent years demands an explanation. The answer that CEOs are now more important is not it. Being a CEO of a large public company is still a tough job but not more than twice as tough as it was 20 or 40 years ago. A more likely explanation is that the model for determining executive pay lacks any effective protections against over-paying.
No real evidence is available to support the claim that CEOs are more important. However, the fact that CEO tenures have got shorter is a matter of record. In the 1960s, an average share in a company would be held for four years. Due to the growth in high frequency algorithm trading (HFT) shares and corresponding voting rights are held on average for 20 seconds. HFT accounted for around 40% of market activity in Europe by 2010 according to a study commissioned by UK government into execution costs. The pay being measured and talked about is public company pay, and the changes in stock markets are much more dramatic than any change in CEO job content. Markets are much more short term in their outlook. For CEOs trying to demonstrate success this is a challenge. The possibility that the financial rewards for being CEO may be transitory creates an incentive to cash in. For some CEOs it is a question of now or never.
Changes in tax and regulation explain the rise in top pay
Critics suggest that changes to tax and regulation help explain why executive pay is higher than it used to be. Let’s be clear: nobody has passed a law that amounts to a hard cap on the quantum which an individual can earn, just as nobody has introduced a minimum wage for executives. Rules in this area tend to be more akin to nudges towards what is perceived to be better behaviour. There is nothing inevitable about the reaction to such regulation. You can hardly blame the members of Parliament who voted through the 1984 Finance Act including a 4 x face value limit on option awards for the fact that all companies then adopted share option plans and all granted the maximum award possible. The intention of Parliament was clear: excessive awards would be problematic. Companies ignored the spirit of the decision made by the democratically elected representatives of the UK public but nothing forced them to do so. Section 162 (m) of the US tax code which limits the amount of deductible executive pay to $1m unless it is performance-based was intended to restrain unjustifiable awards. The fact that $1m became the going rate for a CEO salary is due to companies ignoring an intention which had been arrived at via a democratic process. Companies were at liberty to act in accordance with the spirit of the rules but chose not to. The regulations don’t explain the rise in high pay. The fact that companies choose to ignore the regulatory intent does.
Performance related pay has caused pay to rise
Variable incentive pay now forms a greater proportion of overall pay than it used to. There is an argument that because the risk of not receiving performance related pay is greater than the risk of not receiving salary then pay has had to rise to compensate for this risk. The argument here is that the rise has been justifiably sharper because of increased risk.
This is true only if you accept the argument that executives needed compensating because they lost out on additional salary. However, there is little evidence that executives have lost out.
Top salaries have increased. FTSE 100 average CEO salary rose 5% per annum on average in the period 1998-2012 according to MM&K Manifest data. According to the logic this should have been a sharper increase and therefore justifies additional compensatory levels of incentive award to compensate for salary sacrifice. Option and LTIP growth in the same period was 1000%. This massively over compensates for the riskier nature of the payment.
Therefore the riskier nature of performance pay doesn’t serve to explain the scale of the increase. In fact incentive pay increases have less to do with compensating lost salary than with share plan rules that fix annual grants according to percentage of salary. Listed company incentive schemes rules usually tie annual award levels to a percentage of fixed salary, and usually award multiples of salary. Any salary increase automatically triggers an increase in award level at a fixed ratio.
Of course, this wouldn’t necessarily be a problem if the performance had matched the pay increases. But this has not been the case. Analysis of pay data and key company performance metrics conducted for the High Pay Centre by IDS in 2015 found that between 2000 and 2013, the median earnings of a FTSE 350 company director increased more than twice as fast as median pre-tax profits at FTSE 350 companies, and four times as fast as their median market value.
Median gains from so-called ‘Long-Term Incentive Plans’, awarded annually to executives for performance over the previous three years, increased by 268%. Over the same period, median earnings per share increased by 81% and the market value of FTSE 350 companies went up by 64%.
It is true that performance related pay has made the pay element of some employees’ terms and conditions riskier. For many other employees terms and conditions are also much riskier, but the added risk is not matched by the potential for greater reward. Labour has become increasingly casualised. The shift from defined benefits to defined contribution pensions has switched investment risk from companies to individuals. Short-term contracts, zero hours contracts and consultancy arrangements are all far more prevalent. Lack of investment by companies in training has required employees to invest in their own skills in return for increasingly short-term commitments by their employer. It seems the exception to the rule when it comes to compensating for greater employee risk is executive pay.
Employee representation can be bad for firms
The question of whether employee representatives should have a role in setting executive pay is usually framed in the context of changes to remuneration committee membership. Remuneration committees continue to be populated by non-executive directors whose experience of pay at other companies in an executive capacity informs their tolerance for high pay. The theory behind adding employee representatives is that the contribution of members with more normal pay experience might mitigate the normalisation of excessive executive pay. It could work. It might not. There is no reason to assume it would result in worse pay outcomes.
Before changing a committee’s membership it is first worth considering how the committee in question has used the discretion afforded it. A shareholders’ (and public) view of how a committee has performed is informed entirely by what they do (awards, payments and policies are all well disclosed), but never by what they don’t do. To dismiss such committee entirely would be a classic case of ignoring the known unknowns. I was struck by a recent conversation with the head of HR at a FTSE 100 firm which had undertaken recruitment for a senior executive. It became clear that the company had rejected a shortlisted candidate on the grounds that his demands were excessive. Shareholders will never have the opportunity to endorse the backbone showed by the committee members. No details of their decision not to appoint will ever be formally disclosed. How many more examples of committees holding the line against unreasonable demands are out there?
UK disclosure rules changes in 2013. This year will be the first year in which committees are obliged to disclose details of how they have used discretion. Whilst respecting confidentiality committees ought to be able to demonstrate how they have held the line against unreasonable demands. Those that cannot should consider whether employee representatives might stiffen their resolve.
It’s shareholders money, and if they are not bothered why should we be?
Proponents of high pay argue that it is shareholders’ money, so it is a matter for shareholders to resolve if they believe there is an overpayment. The reality is that institutional votes are dislocated from beneficial ownership. The returns on shares for which votes are cast by asset managers on pay and other issues belong to the asset management clients. Asset managers are investing with other people’s money. Asset managers themselves are highly paid. This dislocation between beneficial owners and exercise of voting rights is an inconvenient truth for arguments which rest on the assertion that it is “shareholders’ money”. It poses the possibility that beneficiaries are not as happy with pay outcomes as their well-rewarded managers’ votes suggest. Information which allows asset owners to hold managers to account is not always well disclosed. This is consistent with the FRC’s decision to start publicly naming asset managers from mid-2016 whose reporting to clients does not meet expectations.
The idea that it is shareholders’ money miscasts shareholders in the role of exclusive owners of the company. This ignores the fact that generally speaking shareholders do not have unconditional access to the assets of a company. Limited liability companies are legal entities distinct from their shareholders with separate legal rights and abilities granted by the state.
There is public interest in ensuring society retains trust in business. Nothing erodes trust like awards that are off the scale of even professional managerial experience. A March 2015 survey of Institute of Directors members placed excessive executive pay at the top of issues which threaten the reputation of business. Business cannot and does not exist in splendid isolation. Just as society looks to business to provide economic resilience, jobs, taxes and incomes, business looks to civil society to provide rule of law, health services, transport infrastructure, security, and an educated pool of employees and potential employees. This relationship is symbiotic not mutually exclusive.
Critics of the High Pay Centre have invited us to point to ways in which the executive pay market is broken. Evidence of exactly this comes in the form of closed recruitment for the kind of positions that attract outsized pay awards. Rent seeking is encouraged by a system in which the job is marketed only to the selected candidate instead of a competition between candidates for an openly advertised position.
The benign explanations for why pay at the top of the income distribution has soared lack substance. But it has happened. This change is unprecedented. It shouldn’t go unobserved. For the High Pay centre the work continues.