What does 'Fair' mean in executive pay?

This is the text of my presentation at the High Pay Centre's event at the Tory Party Conference last night.  The question was:

THE BIG PAY DEBATE – CAN THE CONSERVATIVES BE THE PARTY OF FAIR PAY?

Other speakers were Frances O'Grady, General Secretary of the TUC; Nadhim Zahawi, Conservative MP; and Anthony Browne, CEO British Bankers Association. 

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In the New Testament, Matthew 19:27, we hear The Parable of the Vineyard Workers.  Some of them worked in the vineyard all day; some worked half a day; some worked only an hour.  But each of them was paid exactly the same amount at the end of the day.  There were some pretty angry people around at that point.  Let me quote you the vineyard owner:

“'Friend, I am not being unfair to you. Didn't you agree to work for a denarius? Take your pay and go. I want give the man who was hired last the same as I gave you. Don't I have the right to do what I want with my own money? Or are you envious because I am generous?"

Thankfully, this parable is about getting into Heaven, and not about fairness in pay.  Because most of us would think that he is being unfair, and that those who worked hardest should get more.

So, fair pay obviously isn’t about equality of outcome.  But what is fair pay?

I did a PhD to try to resolve this.  I failed – not the PhD! – just in finding the answer.  There isn’t an answer.  So instead of researching ‘How should we pay the directors?’  I decided to ask ‘How do we pay the directors?  How do you decide how many zeroes come at the end of the first number?’

And I can summarise my 100,000 word PhD in fewer than 140 characters – “I want this much, because he’s got that much.”

When you look at the research on executive pay, you come across ‘fairness’ in various forms.  I can summarise it like this:

·         Pay has to be fair

·         Pay has to be seen to be fair

·         Pay has to be seen to be set fairly.

What we need to consider is fairness of Outcomes; Transparency ; and fairness of Process.

We know from research that people are prepared to accept wide differences in pay if they perceive the process of pay determination as following fair and transparent rules.  It’s what academics call Procedural justice. And it is fundamental.

I think that that is one of the reasons why we use ‘the market’ as a benchmark for executive pay packages – if the sum is determined externally’ by ‘the market’ then we can see how we came by the number, and so that is a tick in the box.  The problem is, of course, that ‘the market’is a myth.

When economists talk about a market they mean the intersection of supply and demand curves for a product which is in wide supply and where every unit is interchangeable.  They also imply complete transparency and full knowledge and no transaction costs.  None of these things apply in exec pay – individuals have different qualities and experience, and jobs require different attributes.  And ‘the market’ only covers those companies against whom we choose to benchmark.  So it’s not really a market at all. 

However, if you take benchmarks out of the equation, what do you put in their place?  I’ve been asking that question a lot recently, but there aren’t any really good answers coming back.

What we need to do – somehow – is reset that benchmark.  I’ve always been struck by a comment made to me by one of the CEOs I interviewed for my research.  He said:

If the salaries for the average FTSE chief executive were half as much, … they would still be more concerned about that relativity than they would about whether it’s half.

At the top, it’s not really the amount – it’ all relative.

Please note – I am definitely not suggesting a statutory cap on executive pay to bring it down.  I don’t think that would work.  (The Roman Emperor Diocletian  tried it at the beginning of the fourth century, in order to ‘establish justice’ among his people, and stop inflation.  It didn’t work then, either.)

But …Moving on from just benchmarks…

I think the need to be Fair also influences the desire to reward performance with pay.  Performance-related pay has been a fundamental part of the UK’s executive pay system – indeed the world’s executive pay system – for the last two decades.  We say in the UK Corporate Governance Code that a “A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance.”

We ask for the pay-performance link because it is seen as fair.  Going back to the parable of the vineyard – those who do the most, who contribute the most, who achieve the most – they should get more reward.  But we haven’t got it right yet.

We are all familiar with the perverse incentive that bankers had to take excessive risks, knowing that if the gamble paid off they got a huge bonus; and if it didn’t pay off we picked up the bill.  That, in part, is a function of the fact that it is really, really difficult to design performance measures and targets that will be meaningful, achievable, and not dysfunctional.

It’s also difficult to design pay that is fair to the Executives, to the Shareholders and to the other Stakeholders, because everyone has different interests.

But the other problem with performance-related pay is that we also know, from research, that pay is not a marvellous motivator.  Motivation comes in two flavours: ‘intrinsic’, that relates to one’ desire to do the job, and ‘extrinsic’, relating to the monetary reward, the pay.  There is a lot of work done that demonstrates that having a large extrinsic reward is actually detrimental to performance for people doing complex cognitive tasks.  Which is a pity; complex cognitive tasks are exactly what we want from our executives.  I’m not saying we should – or could – get rid of bonuses; I think they have their place; but it’s interesting that fairness in rewarding good performance might have negative implications.

I’m coming to the end of my time, so I’d like just to revisit the concept of ‘fair’ with a series of questions.

If an oil executive gets a multi-million £ bonus for producing great profits at a time when the oil price is very high, so anyone could make money: is that fair?

If that same oil executive doesn’t get a bonus when the oil price falls to $10 – which it has in the past – is that fair?  Even if he has managed to contain the losses so that the performance is extraordinarily good in the circumstances?  Is that fair?

If the pay of a female executive rises by, say 33% to be equal to the pay of her male counterparts: Is that fair?

If Stephen Hester, who gave up a well-paid position to come and run RBS and did a great job of it, and improved the tax-payers’ position … if Stephen Hester can’t get a bonus for doing that: is that fair?

Thank you.