Theresa May is absolutely right to ensure that the UK does not work for just “the privileged few”. But her suggestions for reforming executive pay – while well-intentioned – are not backed up by evidence and may well backfire.
Before addressing the specific suggestions, let’s first ask whether the government should be intervening in the first place. A contract is a private agreement between an employer and an employee. It’s not clear whether the government should interfere, just as it doesn’t with other highly-paid employees, like athletes, entertainers, and lawyers.
A common argument is that pay has indirect costs – it causes chief executives to take actions that affect society. But there is very limited causal evidence that pay has these effects. Moreover, firms take many other decisions that have far larger effects on society – firing workers, restructuring, or changing leverage – which are rarely regulated. Thus, pay regulation may be driven by politicians’ desire to be seen as tough, rather than pay actually being a critical social decision.
And we have remedies for bad decisions. Private equity firms and hedge funds are not afraid to make major changes – they improve operating performance, increase innovation, and even fire the chief executive in many cases. But they very rarely cut the chief executive’s pay. While large investors see many things to fix in a firm, the level of pay doesn’t seem to be one.
Government intervention may be not only unnecessary, but also harmful. A policy-maker should exhibit similar caution to a doctor. The Hippocratic oath is “first, do no harm”, but the history of compensation regulation is filled with unintended consequences. Bill Clinton’s $1m salary cap led to chief executives below the cap raising their salaries to $1m, and those above merely reclassifying salary as bonus. The recent EU caps on banker bonuses led to salaries rising instead.
May’s first proposal is to force firms to disclose the ratio of chief executive pay to median worker pay. It’s right to ensure that the chief executive is not overpaid. But the correct benchmark is what chief executives at other firms are getting paid, or the chief executive’s performance – not the pay of average workers, in completely different jobs. The evidence shows that firms with high pay inequality exhibit higher operating performance, valuations, and stock returns.
Moreover, a focus on pay ratios can increase inequality. A chief executive can lower the ratio by firing low-paid workers, converting them to part time, or increasing their cash salary but reducing their non-financial compensation (such as training and working conditions). These concerns aren’t scare-mongering, as evidenced by the unintended consequences of prior regulation.
May’s second proposal is to put workers on boards. The referendum has shown how crowdsourcing economic decisions – while seemingly democratic – can lead to the decisions being uninformed. Employees rarely wish to weigh in on R&D policy, since this should be left to the experts – the scientists. But everybody believes that they are an expert on chief executive pay, even though economics requires as much expertise as science.
An employment contract is extremely complex, covering topics such as the optimal way to filter out industry performance (indexed options? indexed stock? options on indexed stock? stock with indexed performance vesting thresholds?) Confused? Well, so might employees be. The discussion may focus on the “optics” of pay (e.g. a low ratio) and ignore more important dimensions, such as performance targets being long term rather than short term. The median size of a FTSE 100 firm is £7bn and median pay is £5m. Even if a chief executive were paid double, that costs 0.07 per cent of firm value. If chief executive pay is tied to short-term performance, she might take myopic actions that reduce firm value by several percentage points.
Employees often come up with ingenious ideas. But companies already have strong incentives to consult them. I found that firms with high employee satisfaction – for which communication is key – beat their peers by 2-3 per cent per year. We want to push the message that employees and executives are in partnership – consulting the former is good for the latter – rather than employee consultation destroying value. Evidence shows that worker representation on German boards is associated with lower profitability and firm value.
May’s third proposal is to make say-on-pay laws binding. While I’m less concerned about this, again it seems motivated by the desire to appear tough rather than evidence. A study of say-on-pay laws in 11 countries finds that advisory votes reduce pay and increase pay-performance sensitivity, but binding votes are less effective. Moreover, shareholders have told me that binding votes will require them to focus too much on the pay vote and distract them from other issues such as the firm’s strategy and social responsibility.
Is the message to do nothing? Far from it. When pay is inefficient, it is often a symptom of an underlying governance problem, brought on by dispersed shareholders. Addressing pay via regulation will solve the symptoms; addressing dispersed shareholders will solve the problem and improve not only pay, but governance more generally. The Purposeful Company Project, spearheaded by The Big Innovation Centre and the Bank of England’s Andy Haldane, proposes creating large blockholders, merging sub-scale pension funds, and “safe harbour” provisions to allow small shareholders to engage collectively.
Politicians aim to win votes, but it’s large shareholders who have incentives to ensure their firm creates sustainable value. The electorate will be more impressed by a politician that halves pay than one that extends the vesting horizon from three to seven years, even though the latter will have a far greater impact. The goal of compensation policy shouldn’t be to write headlines, but to create long-term value for society.