The impact of high pay

by Michael West | Oct 11, 2011 | Business

Chief executives’ pay and performance may not be closely correlated. Photo: Gabriele Charotte

“The impact of high pay? Execs buy a third house, they get attacked by professional fund raisers, they spend money on stuff that takes up the thinking time.”

These are the words of the former chief executive of a top share market-listed Australian company who weighed into the executive pay debate in the wake of BusinessDay’s coverage yesterday on the inefficient market for executive labour.

Execs don’t work better when (the) shares rise, they get comfortable and take too many risks

Speaking on condition of anonymity, the executive said the impact of high pay on executive performance was “negative”. Further, he argued that aligning management with shareholders through equity was based on a “fallacy of logic”.

“In fact, it is the opposite. Executives don’t work harder when the company’s shares fall in value, they panic.

“Execs don’t work better when (the) shares rise, they get comfortable and take too many risks.”

Executive share schemes, he said, were based on a “further tier of bulls***”:

“Shareholders hold a tiny fraction of their wealth in each company, but execs get share ownership schemes that can mean over 50 per cent of their wealth is tied up in the company shares. This is not alignment to begin with and leads to other distortions.”

Radical view

The comments are quite radical coming, as they do, from a member of the executive class. For the purposes of a media story, they are somewhat weakened by the anonymity of the former chief executive. His wishes to remain anonymous though are understandable.

“I have been highly paid, participated in share ownership schemes, and approved seven-figure remuneration packages for executives,” he said.

In the interests of getting the other side of the story we can assume that all executive peak bodies and spokespeople would disagree with these views.

Issues of structure and packaging excepted, the rationale for the proponents of executive remuneration is based on the logic that “the higher the incentives, the better the performance”.

It should be said though that there seems to be an absence of research to prove this.

What counts

While there is no doubt that remuneration is a motivating factor in performance. The real debate surrounds the structure and the size of the remuneration and when and how these factors become spurious to performance, or even negative.

It would seem logical that a $10 million paycheque did not ensure twice the performance of a $5 million paycheque. This extra $5 million of shareholders’ money therefore is wasted.

Optimal option

What is the optimal approach? Is there any evidence that this lavish US-style remuneration (it’s lower in Europe and elsewhere) enhances performance?

We spoke with Amanda Wilson, the managing director of investment advisory and governance research group Regnan.

Wilson, who has been involved in executive pay for over a decade, says many of the perceptions surrounding the debate are based on a “pseudo-science”.

For a start, there is the contention that CEOs are entirely responsible for the performance of the companies they lead. In fact, the act of “bringing in a star” is often self-fulfilling, says Wilson.

The share price might rise in the short term yet the effect of the CEO’s decisions on a corporate empire which has endured for, say 100 years, can be marginal.

Funds managers, she says, will regularly approve extravagant pay packages if shareholder returns are acceptable but even when those returns are due to factors outside the executive’s control: a booming stock market, for instance, or a changing industry structure, the elimination of a competitor, changing laws.

‘Value destructive’

Paying too much can often be “value destructive”, says Wilson, pointing to the Occupy Wall Street protests and, closer to home, the furore engulfing Qantas where executive pay is high yet a thousand staff are being cut.

At the bottom of the food chain, she wrote in a recent paper, the workers are expected to be happy to exchange their labour for a set amount of money and the opportunity to progress.

“At some point closer to the top, the prevailing orthodoxy tells us more is required. So while the average fixed remuneration for a chief executive of an ASX 200 company is $2.7 million, this will not motivate these individuals to do their best.

Dogma bites boss

Rather, to get top executives to deliver, “they need incentives on top of the $50,000 they make each week in their base pay. It is this dogma, and the enormous pay packages it inspires, that most undermines some of the key tenets of capitalism.”

Capitalism, she says, accepts large disparities in wealth on the basis that economic dynamism requires risk-taking married with intrinsic merit, and that “this virtuous marriage will only emerge if it is financially rewarded”.

“But what is the chief executive risking if he is earning close to the average annual wage every week before bonuses?”

This is now a market in a bind. Having made pay public information, there came a salary spiral, and now that the norm is so high there is a disappointment factor if the package is not astronomical. This can be demotivating, says Wilson.

Another accepted tenet in the debate is that the market for executive labour is fair and global, and the talent pool is small.

Conflict

For a start, search firms and remuneration consultants are paid on size of package – a clear and relentless conflict.

Countervailing this ‘talent pool’ argument is the issue of artificial barriers says Wilson, such as the supposed pool being mostly male.

A recent study commissioned by the Australian Council of Superannuation Investors (ACSI) showed that, from 2003 to 2007, only 4.3 per cent of departing senior executives were lured offshore; 13 per cent were recruited to other Australian companies, 35.7 per cent were terminated, 33 per cent retired and 7 per cent moved on because of divestment.

This hardly points to vigorous global demand.

No lift

Coming back to the issue of equity-based performance structures, Wilson contends there is little evidence of any kind to suggest that equity incentives such as options lift organisational performance at all.

“One review of more than 220 studies concluded that equity ownership had no consistent effects on financial performance. Another massive study and review of research on executive compensation published by the National Bureau of Economic Research reported that most schemes designed to align managerial and shareholder interests failed to do so; instead, executive compensation practices just operated as devices to enrich senior managers,” she notes.

Providing lavish incentives to our most senior employees, argues Ms Wilson, leads to perverse outcomes.

  • It encourages the creation of artificial barriers to entering their labour market.
  • It corrupts the assessment of corporate performance as interested parties vie for attribution of performance that is clearly the result of luck or circumstance.
  • It perverts the process for people climbing the ladder to break into this can’t-go-wrong cabal.It discourages and alienates people down the chain and makes them feel the supposed link between merit and reward in their own positions is a sham.
  • It invites a backlash from regulators, shareholders and the public at large.

Adam Smith, she says, would be appalled.

Michael West established Michael West Media in 2016 to focus on journalism of high public interest, particularly the rising power of corporations over democracy. West was formerly a journalist and editor with Fairfax newspapers, a columnist for News Corp and even, once, a stockbroker.

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