Paste your Google Webmaster Tools verification code here

Investors should intervene to stop high executive pay, before the regulator does

Investors should intervene to stop high executive pay, before the regulator does

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.

As published in City AM Wednesday 18th July 2018

Image: Fat Cat by Linnaea Mallette is licensed under CC-BY-1.0
Read More

Sorry, Prime Minister: Legislation won’t end excess in the boardroom

Sorry, Prime Minister: Legislation won’t end excess in the boardroom

A key platform of our new Prime Minister is to curb what she perceives to be boardroom excesses.  “It is not anti-business to suggest that big business needs to change”, she said.

One of her proposals is to allow employee and worker representatives to sit on company boards, a suggestion which has not gone down well in the corporate world.  The debacle at the Co-op, with its legion of elected directors, has been cited many times as an argument against Mrs May’s idea.  First Group already has employees on the boards not just of its component companies, but of the group plc itself.  However, given that one of the companies is Great Western trains, one of the most notoriously unreliable of all the rail operators, this has not proved to be a panacea.

May is keen on making shareholder votes on executive remuneration legally binding.  True, in the spring, a clear majority, some 60 per cent, rejected BP boss Bob Dudley’s £14 million pay.  But only 33 per cent of shareholders failed to back Martin Sorrell’s package at the WPP AGM last month, even though both Standard Life and Hermes, two of Britain’s most influential fund managers, voted against the pay report.

Board members receive emoluments.  Shop floor workers get pay.  Yet however we describe them, the gap between the two has opened up in dramatic fashion in recent decades, with no obvious economic justification.  In the United States, for example, the average compensation of CEOs in the top 350 firms is some $15 million a year.  This enormous sum is 300 times higher than the amount the companies pay to the typical worker.  In the mid-1970s, the ratio was not 300:1 but only 30:1.  Even in the mid 1990s it was around 100:1.  This latter figure would still hand the average CEO some $5 million today, not a bad sum to have.  The American economy has done well, but it also did well in the decades immediately after the Second World War, when remuneration disparities were much narrower.

Legislation is the brutal option, but there is no guarantee it would work.  The fundamental challenge is to alter the set of values which has become dominant.  The social norm at the top of industry has become one in which it is perfectly acceptable to be paid very large amounts, virtually regardless of performance.  This behaviour has influenced remuneration in non-market sectors of the economy, such as the pay of top management in universities, and in particular that of Vice-Chancellors.  Their average salary in 2014/15 was £274,000.  Incredibly, the Vice-Chancellor of Falmouth University – it does in fact exist – received £285,000.

There is a simple policy which could radically alter attitudes and behaviour.  The Prime Minister should let it be known that no-one who behaves in an ostentatious way on this matter will either be knighted or elevated to the Lords.  Indeed, such honours might be reserved for captains of industry who volunteer for substantial pay reductions.  Miracles might then happen and social norms drastically changed.

Paul Ormerod

As published in CITY AM on Wednesday 20th July

Image: Home Secretary, Theresa May, speaking at the Girl Summit, by DFID – UK Department for International Development  licensed under CC BY 2.0

Read More

There’s little logic to 2016’s shareholder revolts against executive pay

There’s little logic to 2016’s shareholder revolts against executive pay

The crisis at BHS has focused as much on the ethics of Phillip Green’s behaviour as it has on the plight of the company itself.  Sir John Collins, who put his name forward for a knighthood, has said Green should be stripped of it if his handling of the beleaguered company is found to have lacked integrity.

Green is by no means the only prominent businessman to have faced criticism in recent weeks.  Last month, almost 60 per cent of BP shareholders voted at the AGM against the £14m pay package for the chief executive in a year in which the company reported record losses, cut thousands of jobs and froze its employees’ pay.  Hours later, over 50 per cent of Smith and Nephew’s shareholders rejected the remuneration committee’s decision on executive bonuses, despite the fact that its shareholder returns were below the median of its peer group.

It is a natural human tendency to look for specific reasons why these headline grabbing events take place. So we feel that perhaps these attacks were justified because of the varying degrees of poor company performance in each of the examples.  But Sir Martin Sorrell, who has built up a global media business from scratch and really has created shareholder value, is expected to face similar criticisms at the WPP AGM in the summer.

At the opposite extreme, the business world is replete with examples of huge rewards being handed out for poor performance with no comeback at all.  One of the harbingers of the financial crisis in the autumn of 2008 was the collapse of Bear Stearns investment bank in March of that year, and the virtual destruction of its shareholder value.  Yet James Cayne, the chairman and chief executive, walked away unscathed with the $40 million he had been paid in cash.  Fred Goodwin at RBS did have his knighthood annulled, but he was one of the very few financiers to suffer despite the ravages which they caused.

It did seem that revolts against massive pay-outs would take off in the ‘shareholder spring’ of 2012.  The august Institute of Directors pronounced that companies must respond to shareholders’ anger or risk discrediting the wider business community.    In the end, the protests just fizzled out.

In terms of shareholder discontent with executive remuneration, we have examples where poor performance stirs this up, examples where even exceptionally poor performance does not, examples where even good performance provokes the shareholders, and examples where a protest movement simply fades away after lots of initial sound and fury.

So it is challenging, to say the least, to construct a logical explanation of what causes shareholders to get stirred up.   We should think of it instead as being more like a fashion item.  Once something starts to become popular, it is likely to become even more popular, simply because it is popular.  We may just have reached a tipping point, where the large institutional shareholders now feel it is the done thing to pillory top executives, almost regardless of their performance.

Paul Ormerod

As published in City AM on Wednesday 4th May 2016

Image: Sir Martin Sorrell by Chip Cutter is licensed under CC BY 2.0

Read More

FIFA, corruption and economic growth

FIFA, corruption and economic growth

The FIFA arrests have dominated both front and sports pages. We must await the outcomes of the trials before pronouncing on individuals.  But amongst soccer fans, the organisation is a byword for sleaze and corruption. England spent £21 million on the campaign to secure the 2018 World Cup. The height of our attempts to influence the delegates seems to have been the offer of a free breakfast with Prince William in Zurich. Little wonder that we only obtained one vote in addition to our own.

Economics has a great deal to say about corruption. Does it, for example, tend to increase or reduce the level of GDP per head in a country? The answer might seem obvious, but economic theorists are nothing if not imaginative. For example, in almost a caricature of rational choice theory, it has been argued that allowing government employees to solicit bribes provides them with an incentive to work harder. To be fair, however, the overwhelming consensus is that corruption is bad for the economy.

A key figure in the debate is Paolo Mauro, for over 20 years a senior economist at the IMF, and now a fellow of the Petersen Institute in Washington DC. His 1995 article in the Quarterly Journal of Economics has become the classic empirical investigation of the impacts of both bureaucracy and corruption on growth. He constructed a detailed data base across 67 countries, summarised in a bureaucratic efficiency index. This combined data on red tape, the independence of the judiciary, and corruption.

Mauro divided his sample into six different groups, depending upon the level of his index. There is a very strong correlation between membership of these groups, and whether or not a country has actively supported Sepp Blatter in FIFA. The African countries, for example, are almost all in the bottom two groups in terms of efficiency, and the top two are made up of Western Europe, America, Canada, Singapore and Japan.

The negative impact of corruption on growth is strong. The results of Mauro’s sophisticated statistical analysis are not straightforward to present. But, as an example, if Nigeria could somehow move from the most corrupt of his six groups to the third most corrupt, its economic growth rate would improve by as much as 1 per cent a year. If the country had done this over the whole period of its independence from the 1960s, income per head would be 65 per cent higher than it is now.

The problem of course is that a culture of bribery and corruption is self-reinforcing. In a corrupt society, it is in the collective interest to move to a much lower level of corruption. But it is not really in any individual’s interest to try and do so. If you take bribes, you will lose them. And if you expose bribes you will be ostracised, maybe even killed. This clash between the collective and the individual interest means that markets cannot solve the problem. I rarely praise the bureaucrats of the OECD in Paris, but their anti-bribery campaigns deserve support.

As published in City AM on Wednesday 3rd June 2015

Image: soccer_ball_2019 by Paul Sleet under license CC BY 2.0

Read More

Popular culture is the driving force of inequality

Popular culture is the driving force of inequality

The Oscars have come and gone for another year. Winning an Oscar is very often the basis for either making a fortune, or turning an existing one into mega riches. Jack Nicholson has an estimated worth of over $400 million, and stars like Tom Hanks and Robert de Niro are not far behind.

Even winners who lack the instant recognition of these stars do not do too badly. Cuba Gooding Jnr has recently starred in the American civil rights film Selma. But after his 1996 Oscar for a supporting role in Jerry Maguire, he became notorious amongst film buffs for appearing in movies which were panned by critics and which tanked commercially. This has not stopped his wealth rising to an estimated $40 million.

The Premier League has provided us with another example of success apparently reinforcing success. Its recent TV deal with Sky and BT Sports is worth over £5 billion. Along with investment banking, soccer is one of the few industries which practices socialism, with almost all the income of the companies eventually ending up in the hands of what we might call the workers. The year immediately prior to the financial crisis, 2007, still represents a high point in the annual earnings of many people. But the average salary of a Premier League player has risen over this period from some £750,000 to almost £2.5 million.

At one level, films and football seem to provide ammunition for the sub-Marxist arguments of people like Thomas Piketty, arguing that capitalism inevitably leads to greater inequality. The rich simply get richer. This conveniently ignores the fact that over the fifty years between around 1920 and 1970, there was a massive movement towards great equality in the West, in both income and wealth.

During the second half of the 20th century, a profound difference in communications technology opened up between the world as it is now and all previous human history. Television by the 1960s had become more or less ubiquitous in the West. Vast numbers of people could access the same visual information at the same time. The internet has of course enormously increased the connectivity of virtually the whole world.

These advances in technology have altered the way in which people respond to information. The importance of social networks in influencing the choices made by individuals has risen sharply. The economic model of choice in which rational individuals carefully sift all the available information is no longer even feasible in many situations. Almost all click throughs on Google searches, for example, are on the first three sites which come up. It is simply not possible to work through the thousands, or even millions, of sites which are offered.

This means that self-reinforcing processes are set up. Things which become popular become even more popular, simply because they are popular. And because of communications technology, we know what is popular. In popular culture, a rapidly growing sector of the economy embracing both films and soccer, high levels of inequality of income are inevitable

As Published in City AM on Wednesday 25th February 2015

Image: Academy Award Winner by Davidlohr Bueso licensed under CC BY 2.0

Read More

Bring Back Cedric the Pig!

Bring Back Cedric the Pig!

Executive bonuses are back in the news. The Goldman Sachs pot of £8.3 billion has been prominent. German executive pay has overtaken that in the UK for the first time. Top management seems to have no shame. Some bad publicity today, but the fat cheque remains safely in the bank account.

How one longs for the days of Cedric the Pig! This was the unfortunate nickname bestowed upon Cedric Brown, the Chief Executive of British Gas whose salary was increased by 75 per cent to £475,000 at the end of 1994, at a time when the company was making staff redundant. This works out at just over £700,000 at today’s prices. We can usefully contrast this with the remuneration package of Iain Conn, the newly installed Chief Executive of Centrica, parent company of British Gas. We read on the Centrica website that his basic salary is £925,000. Well, perhaps not an indecent amount more than poor Cedric. But the text goes on ‘to provide continuity of incentive opportunity prior to new arrangements being established two transitional awards will be made’. ‘Continuity of incentive opportunity’ means he could be in line for share awards of up to three times his base salary, plus pension contributions and ‘other benefits’.

Compared to many leading companies nowadays, the remuneration committee of Centrica has acted with a certain amount of restraint. Last year, the average FTSE Chief Executive was paid 143 times the salary of their average workers.

Perhaps economic theory can be used to justify these various payments? An essential component of any basic course in economic principles is the so-called marginal productivity theory of wages. ‘Marginal’ here does not have its everyday meaning in English, but is a piece of scientific jargon. It means the additional value contributed to the firm by a particular worker. According to the theory, the massive increases in executive remuneration over the past two decades or so are entirely justified. People are paid what they are worth. Certainly, this sentiment is prominent in corporate justifications for pay packages. World class individuals are needed, who can deliver world class performances.

There are many practical criticisms of this description of how pay is determined. Yet even within the abstract confines of economic theory itself, it cannot be justified. Economics has no theory with which to explain the distribution of income. This result, which required many pages of maths to prove, was established as long ago as the early 1970s. The lineage is impeccable. Gerard Debreu received the Nobel Prize for his work on equilibrium theory, and Hugo Sonnenschein went on to become President of the free-market oriented University of Chicago. But only high level graduate students, once they have been thoroughly socialised as economists, are taught these theorems.

The simple fact is that executive pay is almost entirely determined by social values and norms. The sense of restraint, of noblesse oblige, which characterised much of Britain’s post-war history, has vanished. Until top management learns to behave respectably again, the problem will remain.

Paul Ormerod

As published in City AM on Wednesday 21st January

Image: Piggy Bank by Pictures of Money licensed under CC BY 2.0 

Read More