Executive pay regulation will backfire if it’s not based on evidence

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Executive pay is the poster child for the gap between big business and ordinary people (Source: Getty)

Executive pay is the poster child for the disconnect between big business and the general public. It does need to be reformed. It needs to be fair given an executive’s performance – and performance as measured by long-run contribution to society, not short-run profit.

However, 80 years of history shows that compensation reform has frequently backfired. To develop solutions that work, we need first to consider the evidence. The public would be outraged if drugs were released without scientific evidence for their effectiveness, but everyone thinks they are a pay expert. Yet pay, and the economics on which it is based, is just as complex as science, and evidence is just as valuable. In other words, before prescribing the cure we need a correct diagnosis.

Reports are coming out from a range of commentators and bodies arguing for change. Several do aim to base their recommendations on evidence, which should be applauded. But unfortunately that evidence is often flawed. Only once we have the facts should we start making proposals, just as rigorous diagnosis precedes treatment.

Three common arguments are used in favour of new regulation, all of which can be challenged by a careful review of the evidence.

Read more: Use Nobel-winning insights – not anecdote – to guide executive pay reform

The first is that companies often ignore high shareholder votes against pay packages. In fact, companies receiving less than 80 per cent shareholder support improve their vote the next year by an average of 17 percentage points, suggesting they do respond to shareholder concerns. Only 2 per cent of companies receive below 80 per cent two years in a row.

International evidence across 11 countries that have introduced say on pay rules shows that they have been very successful in improving pay practices. However, there is no evidence that binding vote regimes work better than advisory ones. If anything the opposite.

The second argument is that pay has risen rapidly, in particular relative to the average worker. This is indeed true. However, this claim ignores large quantities of evidence that chief executive pay in listed companies has not risen any faster than pay in other highly-skilled occupations, such as medicine, entertainment, sports, private equity, and fund management. This suggests high chief executive pay is part of a broader economic phenomenon – scarcity – rather than a market failure at listed companies. Moreover, the rise in chief executive pay can be explained by the recent rise in firm size. If the chief executive adds 1 per cent to firm value, this is £10m in a £1bn firm but £80m in a £8bn firm (the current average size in the FTSE 100). In contrast, most workers are less scalable. An engineer who has capacity to maintain 10 machines adds the same value regardless of whether the firm owns 100 or 800.

Read more: Inequality doesn’t matter if we’re paid according to the value we create

This doesn’t make inequality any less of a social problem. But it does suggest that focusing on listed company chief executive pay to the exclusion of other occupations is misguided. Inequality within companies is not the valid starting point for addressing inequality within society.

The third argument is that pay is not linked to past performance, and that high pay even leads to future underperformance. These claims are based on three main pieces of evidence: a widely-quoted recent MSCI study, an academic study on US data, and an academic study on UK data.

These three studies all share common problems. First, by focusing just on pay awarded in one year, they ignore a major part of chief executive incentives, which come from changes in previously-granted equity. Second, they fail to control for many important variables: size or risk. The main MSCI results may simply reflect the fact that over the period of study US small cap companies (which pay less, due to the size-pay link described earlier) outperformed large caps. Indeed, the US study shows that, when controls are added, all components of pay become insignificant except for options, which are not used in the UK. Third, they only show correlation, not causality. It could be that firms with bleak prospects, which would have performed poorly anyway, need to pay more to attract executives.

Read more: Beware the unintended consequences of May’s flawed executive pay proposals

Instead, correctly-gathered evidence shows that pay is linked to performance: the impact on a chief executive’s wealth of a 10 per cent fall in the stock price is equivalent to a pay cut of around $8m for Fortune 500 chief executives in the US and £1.5m for FTSE 100 chief executives in the UK. Firms with high total equity holdings (including previously-granted equity) outperform low-equity ones by 4-10 per cent per year over the long term, and the effect is strongest where the chief executive has greatest discretion, i.e. incentives are more valuable – addressing concerns of reverse causality, that chief executives are more willing to accept equity if they know their firm will do well. Long-term equity has a positive causal effect on future profitability, CSR, and innovation.

The history of pay regulation is littered with measures that have been ineffective or even counter-productive. To ensure we don’t repeat the mistake, we must start with the correct evidence. It is from this starting point that we should propose reform.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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