Conditions of ordinary workers throughout much of the world today are dictated by markets. Employers only want to pay their employees up to the value they create. Wages in excess of this lead to unemployment. Even then, workers might not have jobs. A US employee’s most productive efforts could fall short of what someone can do in China, for example. The idea of a living wage is passing into the mists of time. Even in parts of Europe and in Australia, which clung longest to this idea, the battle has already been lost.
Meanwhile, over the last 30 years or so, senior executive incomes have undergone a seismic upward shift. A recent working paper published by the US Federal Reserve Board looked at long term trends in executive compensation to help throw some light on why this happened. The authors observed that the level of executive pay had increased at only a modest rate from the mid 1940s to the mid 1970s. However, it began rising at an increasing rate from the 1970s to the present.
The same study found that the composition of executive compensation also changed considerably. Stock options and other forms of incentive pay became larger shares of total compensation. Importantly, in terms of the public acceptance of these changes, there was a widening gap between the salaries in the executive suite and the wages on the shop floor.
Some are tempted to treat this executive earnings J-curve as the workings of the market. On their arguments, high executive salaries reflect special skills and the organization-wide impact of their application. It might be possible to justify some very high numbers.
Global mining house BHP Billiton recently appointed a new chief executive. At the time of the decision, BHP had funds employed in the business of some $42.9 billion with a return of around 35%. With a cost of capital in the vicinity of 9.5%, the company was producing an annual economic profit of $2.3 billion.
Let’s say directors had a choice between two candidates for the top job. One was a world class executive, highly experienced and able to sustain the 35% return. This would be no shabby effort. The second candidate was also world class but could get just a little bit more from the business, perhaps no more than 1%, but more.
For BHP, that 1% difference in economic profit would be $22 million. In theory, the board should be prepared to pay the second candidate up to $22 million a year more than the first candidate if he delivers the extra.
But this suggests that a company with, say, one-tenth of the capital base of BHP and achieving the same return should pay its executives proportionally less. Lesser returns on a smaller capital base should reduce the amount paid by even more. While there is some linkage evident between company size and salaries, by and large this is not happening.
More than market forces at work
There is another piece of evidence that high salaries are not the market’s work. The Federal Reserve study concluded that the acceleration in executive earnings could not be explained. If today’s salaries are the consequence of the market, the market could not have been working prior to the 1980s. If it was working then, it is not working now. Something else intervened.
Among the influences on executive salary levels several stand out as possible causes.
Salaries for business advisers had an impact. Financial market deregulation in the US and low real interest rates in the 1980s fostered a takeover frenzy. Every transaction had a strategic advisor and someone funding the deal. The financial rewards for advisers were tagged to the size of transactions and their complexity. As the sums being paid increased, lower paid corporate executives began to eye enviously the growing financial success of their hirelings. If these were to be the relative rewards, why stay on with all the aggravation of an executive position when you could simply proffer advice and walk away to the next deal?
A second influence occurred in the 1990s. This was most often associated with what became known as the IT bubble. Many founders of IT companies became hugely wealthy, at least temporarily. Since many of the companies newly engaged in technology ventures were cash poor, employees were offered equity options to compensate for their commitment. Many employees also became hugely wealthy.
Executives working in the more mundane widget-making industries cast their eyes enviously at this wealth, too. Some switched jobs. Others used the alternatives as leverage in their own negotiations. Directors at the bigger and longer established companies conceded that their executives had to be worth much more than a start-up one tenth of their size.
Thirdly, with more rigorous corporate regulation, salaries lost their confidentiality. As headhunters learned more about how much senior executives were earning and how payments were structured, it was easier to pitch a deal to lure them to other jobs.
Fourthly, company directors became more risk averse. Sure, a new chief executive might be available at a third of the price but if something goes wrong after the appointment, how do you justify costing the company $100 million while trying to save $1 million? With this thought, directors began pushing their budgets to the limit. Their aversion to risk also drove directors to make a show of scouring the world for the most skilled executive appointments. Outside appointments put more upward pressure on salaries. The chance of an internal promotion was correspondingly reduced. There were no longer rewards for loyalty. It made sense for everyone to respond to higher salaries on offer elsewhere.
Finally, the last 15 years, especially, coincided with falling inflation, widespread reductions in interest rates and greatly reduced macroeconomic volatility. For any level of earnings, these features would mean higher stock values. Since executives had tagged much of their remuneration to stock price movements, they had a windfall.
The most dishonest justification is the assertion that executives deserved the higher salaries because shareholders benefited from higher share prices. This ignores that shareholders had taken a risk by investing. They would have lost if inflation had not fallen. No executive would have compensated them if this had happened!
Executives simply benefited from a macroeconomic windfall which might never be repeated and to which they had made no contribution. Unfortunately, since few executives have been inclined to concede this (in part because they do not understand the connection), the resulting elevated compensation levels were simply used as a base for the next round of salary leapfrog.
Current compensation levels are very much a
function of occasional market failures which have given people with monopoly
power an opportunity to extract higher rewards. In this sense, executive pay
arrangements can be more easily explained by Karl Marx's theory that wealth in a
bourgeois society is allocated on the basis of raw power, despite Adam Smith's
market economy prevailing on the factory floor.
Towards a sense of realism
That does not mean that we should throw up our hands and walk away. Executives can, and should be, more exposed to market forces. Here is my suggestion on how to do it.
Too often, compensation plans are "upwardly sticky". In other words, they only increase and never decrease. But compensation should reflect the range of possible outcomes.
Typically, if a business fails to deliver adequate returns, executives do not get the maximum reward allowable under their pay plan. But businesses should go further. Penalties should apply for poor performance. Perhaps they should be forced to give back a part of last year's benefit if an outcome was not sustainable beyond the end of the previous year. Moreover, executives could be forced to make up a prior year’s shortfall before any new rewards are on offer. In other words, the higher the potential income, the higher the risk losing all of an executive's potential income.
One of the failures in the current remuneration system is the mismatch between the time horizon of investors and the horizon of executives. Today’s public company chief executive might have the top job for as little as four years.
On the other hand, a 30-year-old investing his superannuation funds might have a 40 year horizon for his investment portfolio. Driving a company to maximize a four-year return may not be in the best interests of such a shareholder.
So, if a financial result from earlier years is not sustained, why not demand that the chief executive give up past benefits even if he is no longer employed by the company? In any case, his benefits should flow only after his work has withstood the test of time.
This is a radical attack on executive power, but only with this rebalancing can compensation be aligned with the interests of shareholders. This would also help restore the market’s influence. If executives faced these risks and still ended up with multi-million dollar payments, society might be more appreciative of their efforts.
John Robertson is an economist and corporate investment adviser. He has had over 25 years experience in international financial and commodity markets, corporate strategy, financial and business evaluation and government policy in Australia, London and New York.
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