Time to put the fat cats of capitalism on a diet

In 1965, CEOs of major US companies earned twenty times that of a typical worker. Just twenty years later they earned 59 times more.

In 2007, immediately before the financial crash, the ratio was a staggering 345 to one.

While the crash led to some adjustment, CEO pay remains 276 times higher than that of workers¹.

The UK has followed a similar, though somewhat less extreme, trend. In 1980, CEOs were paid between 13 and 44 times their average employee, by 2013 FTSE 100 bosses earned around 130 times the average worker².

It is not hard to see how a proposal by Britain’s hard-left Labour leader, Jeremy Corbyn, for top pay to be capped at twenty times the wage of a company’s lowest paid worker could find support among 57% of the British public³. While the average CEO pay package was almost £5.5 million in 2015, just a quarter of the FTSE 100 companies were accredited as Living Wage employers – committed to paying a minimum £8.45 an hour in the UK⁴. In America, 50% of the public favour limiting the pay of big business executives⁵.

Growing disparity can be observed across developed nations, but America’s pay gap, and to a lesser extent Britain’s, are particularly acute. Contrary to popular argument, it is not because the market for CEOs is so fierce – analysis by the High Pay Centre of appointments in the Fortune 500 found over 80% were internal promotions. And University of Delaware Research found internal promotions were higher performers⁶.

In fact, other countries have managed without resorting to such excess. An internationally comparative measure is compiled by Bloomberg, with America and the UK topping the list for developed nations⁷. By this measure bosses in America make 300 times that of the average person, while British bosses earn 230 times as much. The ratio for Australia is 113 to one, in France it is 70:1 and in Denmark 83:1, clearly showing that sky-high pay is not a prerequisite of capitalism, but rather a feature of particular market models. Models that have lost the faith of the public.

The rise of share options as part of executive compensation is one reason for this disparity. Already large CEO pay packets in American and UK firms have risen in line with stocks, widening the differential between the pay of executives and their subordinates⁸. American CEOs are particularly likely to have these incentives compared to their European counterparts. Weak corporate governance is another factor, with European firms more likely to experience closer scrutiny from creditors and independent boards. In contrast, American firms are more likely to combine the CEO and Chairman role, plainly undermining the independent scrutiny function of the board⁹.  Harvard Law School found that as well as being an “inherent conflict of interest”, having a combined CEO/Chairman costs more, presents greater risk and delivers lower stock returns over the long term¹⁰.

If the reputational and ethical reasons for pay restraint are insufficiently compelling, investors should consider the findings of Morgan Stanley Capital International’s analysis of company pay¹¹.  On average, companies with lower pay gaps (smaller than the sector average) performed better than those with high gaps (higher than average). The report’s findings are tentative, but MSCI suggest some possible reasons for this: employee cost-saving initiatives exacerbate the pay gap without necessarily improving profitability, and executive remuneration is often tied to short-term performance and lacking independent checks and balances.

Executives are abusing their power in setting their own pay 

It is executive (abuse of) power rather than performance that has driven pay, and absentee shareholders and poor corporate governance has let this happen. The MSCI study found 54% of companies lacked fully independent compensation committee oversight. Research by Harvard Law School clearly shows the cost of poor governance: a separate CEO and chairman model costs 75% of what a combined CEO/chairman costs. Even more tellingly, a separate CEO and with independent chairman, someone who has no current or former business relationship with the company, is even cheaper, with the CEO and independent chairman both making less¹².

Shorty after the crash, Lord Myners, then a Minister in the UK Treasury and himself a former banker, criticised shareholders for behaving like “absentee landlords”, abdicating their responsibilities to challenge pay and behaviour. The madness of a business owner allowing their staff to set their own pay is obvious to most, yet despite the so-called “shareholder spring” this year, few FTSE 100 businesses have lost votes on pay.

Shareholders should think again. Analysis by Marianne Bertrand and Sendhill Mullainathan found that in companies with poor governance, CEOs typically pay themselves more for improvements in profit which arise from luck. They are also more likely to award themselves stock options at lower cost. Adding a large shareholder to the board led to a sizeable reduction in pay for luck, for example, by 23-33%¹³.

The relationship between pay and performance is broken

Ironically, in a model where compensation is increasingly linked to stock value, the rewards senior bankers receive bare little relation to sustained performance. Instead, incentivising short-term profit maximisation leads to reckless behaviour of the sort that brought about the financial crisis.

Recruiting and keeping talent is core to any business, and generous pay packages are one way of competing for the best. ‘Star’ traders in particular are coveted by financial institutions who believe their individual brilliance will deliver millions in profits. Todd Edgar, for example, was reportedly enticed to move to Barclays from JP Morgan with a two-year £30 million cash and shares package for him and his team.

But star performance is often about more than the individual. One study looked at the performance of ‘star’ investment analysts when they transferred from one bank to another¹⁴. Rather than justifying their sky-high pay packages through improved company performance, 46% of those so-called stars performed worse in the first year, generally by around 20%. And far from being a transitional blip, performance was still lower after five years. On top of that, the study found hiring stars had a negative effect on a company’s stock price. The authors are clear: “companies cannot gain a competitive advantage by hiring stars from outside the business”. Yet firms are competing for these ‘masters of the universe’, driving pay packages that are more and more extravagant.

There is no reason to think this hubris is confined to the financial sector, though the pay packages there are the most extreme. The authors of the ‘stars’ study extended their analysis to look at twenty top General Electric managers who took up top jobs elsewhere, finding similar problem with the portability of stardom¹⁵.

Tellingly, another academic paper found that when new CEOs are appointed and paid less than standard for the industry and company size, share performance is roughly average. But when CEOs are appointed on above average packages, they deliver lower returns: “excess pay appears significantly negatively linked to forward profitability”¹⁶.

Capitalism works when it benefits the majority. When wealth creation appears to accrue to an elite few, capitalism appears not as a force for good, but a force for greed. Gordon Gekko writ large. The financial crash vividly exposed the “fat cats” as undeserving of their sky-high pay and that their high pay encouraged them to act unwisely. Their reckless behaviour cost millions of ordinary people their jobs, homes and life savings. And yet a decade on, the gap between executive pay and the wages of ordinary workers is almost as wide as before the crash. If public faith in capitalism is to be restored, the connection between pay and performance must also be restored. Executive pay must be brought under control. Capitalists must themselves end the era of the undeserving rich.

This article is the first instalment in a three part series on the challenges facing capitalism.  The second part will be published tomorrow.

 

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