Executive Remuneration; Are You Worth It?

This was written back in May, but somehow I missed it off my blog.  It has been on Rabbi Naftali Brewer's thoughtful site since then, here.  All I have done here is update a couple of numbers in the example.

It was a really useful discussion we had back in the Spring.  This article reflects the spirit of what was discussed.  As we say, we don't really expect it to come into practice - it is in the nature of a thought experiment: what could make a change in CEO pay?

Executive Remuneration; Are You Worth It?

By Naftali Brawer  and Ruth Bender

Background

This paper is the result of a ‘Creative Conversation’ hosted at the Cass Business School in partnership with Spiritual Capital Foundation. The participants in the conversation represented theoreticians as well as practitioners in the field of executive remuneration.  Each participant was asked to reflect on the state of executive remuneration today and to share their unique viewpoint with the group. What follows below is a structured account of the conversation.

Does higher pay equal greater performance?

It is often argued that the more a talented CEO is paid, the better h/she is able to perform. But this assumption is deeply flawed. In the space of a single generation CEO pay has increased exponentially and there is no evidence to suggest that today’s CEOs are any more hardworking or successful than those of a generation ago.

Unpicking the Arguments

So what are the justifications for this steady increase in executive pay? The question is crucial because their pay far outstrips that of middle to lower ranking staff within the same organisation.

One argument is that Chief Executives assume enormous personal risk in staking their professional reputation on the promise of running or turning around a large corporation. Thus it is compensation for this heightened personal risk, far greater than that borne by middle management, that is being reflected in the generous remuneration. The weakness of this argument is that if risk were the key driver of higher financial rewards, why is it that soldiers, police officers and firemen – in far riskier jobs than CEOs - are paid so much less? And if your answer to this is that these are public sector positions, in a different context with less money available, how about other jobs where high personal risk is assumed by low level employees, such as mechanics on oil rigs?  Many employees in high-risk occupations are not compensated to the same extent as executives.

Another argument put forward to justify executive pay is that it is recompense for the constant travel and the encroachment on personal time. While it is certainly true that CEO live highly pressurized and busy lives, the same can be said for a mid-level employee burning the midnight oil. And CEOs have much better working conditions than most of their staff, and have more people to whom they can delegate their load.

A third argument in favour of increased executive pay is that it would cost the company even more to replace the said executive if s/he were to be poached by a rival company. Embedded in this argument is the belief that CEOs possess rare talent that cannot easily be replicated in others. Against this backdrop it appears corporate boards have little choice but to pay the going market rate if they have any chance of retaining extraordinary talent. A similar line of reasoning is used to defend excessive footballer wages. It takes as its point of departure that there is a very limited pool of footballers who can play at the level of say, a Wayne Rooney. This being the case it makes sense for his club to pay him whatever the market will bear if it does not want to lose his rare talent to rival team. Yet while this may hold true for footballers, the parallel with chief executives can be challenged. Is it really true that the potential to be a star CEO is as rare as that of a premier league footballer? If a talented CEO left an organisation would it really be as difficult to replace him as Wayne Rooney?

What is lost by increasing executive pay?

Putting aside the arguments and counterarguments as to whether CEOs deserve higher pay let’s explore the question from a slightly different angle; what harm is caused by yielding to their demands for increased remuneration?

One response to this is that pay increases for a CEO are less significant to an organisation’s profits than are pay increases to other employees.  That is just basic maths.  Take as an example the UK-based supermarket, Tesco, which employs over 500,000 people.  An award of £1 extra to each employee each week would add over £26m to costs, which is more than all the directors’ salaries and bonuses for the last two years.  Any meaningful increase for a large number of employees is going to have a significant impact on profits, which a high percentage increase to one person’s pay is unlikely to carry.

So does it really matter in the end how much a CEO is paid?

The answer is it does, and for a number reasons.

Firstly, immense gaps between a company’s highest and lowest earners sow deep resentment and jealously. Such differences poison a working environment and corrode a corporate culture. Board members have a responsibility to ensure the smooth running of the corporation and vast disparities in pay undermine this objective.

Secondly, it has been argued that not only does excessive pay not lead to enhanced performance but that it can actually produce the opposite effect, weakening performance. Research has shown that additional pay can reduce performance on complex cognitive tasks.[1] 

An unbalanced focus on monetary compensation can also have the effect of crowding out other important values such as responsibility, the satisfaction that comes from a job well done and identification with the success of one’s company. Michael Sandel makes this argument in a broader sense in his book “What Money Can’t buy: the Moral Limits of Markets.”

What is being done to address this problem?

At the moment very little is being done to address this situation comprehensively and constructively. Too much of the public debate around executive remuneration focuses on fixing the details of a broken system.  For example, the directors’ remuneration provisions of the UK Corporate Governance Code have not changed substantially since they were set out in the report of the Greenbury Study Group in 1995.  In reality what is required is a completely new way of thinking about executive pay.

Creative Solutions

In the open environment of this Creative Conversation, a proposal was made which would overcome many of the flaws in today’s system.  It was put forward, not in the hope or expectation that it would or could be  implemented, but as a thought experiment of what a radical solution might look like.

Three background issues were given as context:

1.    There is public outrage directed towards directors who are perceived as over-paid.

2.    There is public outrage directed towards the companies that pay them.

3.    Remuneration committees are unwilling to reduce executive pay, fearing that good executives will leave the company.

Three research findings, from the governance and psychology fields, were considered in determining a possible solution.

1.    It is not the money itself that motivates executives, but the bragging rights associated with their relative pay compared to their peers.[2]

2.    As discussed above, money does not motivate good performance in complex cognitive tasks.

3.    Giving money to others increases people’s happiness.[3]

Putting these together, one proposed solution as that companies should pay whatever they think appropriate in terms of the ability of the executive and ‘the market’. However executives should only accept part of what they are offered; the balance should be donated – in their name – to company-relevant corporate responsibility spending.

By separating the amount offered by the company from the amount taken by the executive, the demands of the situation can be met.  The executive can retain the bragging rights of a high (offered) package in relation to their peers, and can also benefit from the feelings of satisfaction and happiness of giving money to good causes.  Furthermore, they will not feel the adverse performance pressure that research suggests comes from too high a potential reward for a complex task.  Remuneration committees can be satisfied that they paid enough to influence executive retention, but have at the same time avoided the public opprobrium that they currently experience.  And the company can even take credit – by proxy – from the executive’s transparent generosity towards its CSR objectives.

Now, before readers start getting exercised about the impracticality of this proposal, we should remind you that it is offered in the spirit of a thought experiment.  We are not saying that it will happen; we are not even saying that it should happen; we are putting it forward as one way to address the current issues, in the hope that such a radical suggestion will unfreeze people’s thinking on the subject and lead to more creative, and perhaps more practical conversations.

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[1] For example, Ariely, D., Gneezy, U., Loewenstein, G., & Mazar, N. (2009). Large Stakes and Big

Mistakes. Review of Economic Studies, 76, 451-469.  McGraw, K. O and McCullers, J.C. (1979). Evidence of a detrimental effect of extrinsic incentives on breaking a mental set?, Journal of Experimental Social Psychology, 15(3), 285–294

[2] See for example Bender, R. (2004). Why Do Companies Use Performance-Related Pay for Their Executive Directors? Corporate Governance: An International Review, 12(4): 521-533.  Boyce, C. J., Brown, G. D., & Moore, S. C. (2010). Money and Happiness: Rank of Income, not Income, Affects Life Satisfaction. Psychological Science, 21(4), 471-475.

[3] See for example Anik, L., Aknin, L., Norton, M., & Dunn, E. (2009). Feeling Good about Giving: The Benefits (and Costs) of Self-interested Charitable Behavior. Harvard Business School Marketing Unit Working Paper, (10-012).