Shareholder discontent over executive pay continues to rise. Last week, the outgoing boss of BT, Gavin Patterson, was in the firing line.
At the company’s annual general meeting, 34 per cent of investors voted against the remuneration report, which included a £1.3m bonus payment to Patterson.
Concern about top pay has spread even to the regulatory bodies in the United States. Traditionally, they adopt a rather hands-off approach, and yet, when they do decide to act, they act decisively.
About 40 years ago, the typical compensation of a chief executive in America was around 30 times more than that of the average employee. By the mid-1990s, this has risen to a ratio of 100 to one, and now it is some 300 times as much.
True, share prices have boomed over this period, but the rate at which the economy has grown has fallen.
Between 1957 and 1987, real GDP in the US grew by 3.5 per cent a year, but by only 2.5 per cent from 1987 to 2017.
Chief executives have not got better at expanding the rate at which goods and services are produced, but they have got better at free-riding on the rise in equity markets.
Against this background, in September last year, the US Securities and Exchange Commission mandated that companies must disclose the ratio of the chief executive’s compensation to median employee pay.
Some may see this as bureaucratic meddling. But the behaviour of board members both here and in America has given rise to what economists describe as an externality.
The decisions to reward the relative failure on the part of executives have consequences outside of the decisions themselves. So while capitalism is by far the most successful economic system ever devised, the perception that executives are receiving unfair levels of compensation is undermining belief in capitalism itself. This is the externality.
In economic theory, the existence of externalities provides a sound justification for intervening in the workings of the free market.
A fascinating paper published a year ago by Ethan Rouen of Harvard Business School provides strong evidence that unwarranted executive pay levels adversely affect firm performance.
He obtained very detailed data, some of it not publicly available, from the US Bureau of Labor Statistics for 931 firms in the Standard and Poor’s 1,500 between 2006 and 2013, including total employee compensation and the composition of the workforce.
Overall, Rouen found no statistically significant relation between the ratio of executive-to-mean employee compensation and performance. This is telling in itself.
His results went on to show “robust evidence of a negative (positive) relation between unexplained (explained) pay disparity and future firm performance”. In other words, people do not mind high pay – when it can be justified. It is when the snouts are in the trough that resentment rises and performance suffers.
Shareholder opposition to excessive executive packages is certainly rising, but has rarely been decisive. Investors need to act if they are to avoid the regulators really clamping down.