Tuesday 29 November 2016 4:59 am

Five evidence-based proposals to make sure executive pay benefits society

Alex Edmans is Professor of Finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit.

Theresa May is absolutely right that executive pay needs reform as part of creating “a country that works for everyone”. Today, her government is expected to release a Green Paper outlining measures to ensure that chief executive contracts benefit society, not just the executives themselves.

At The Purposeful Company, we applaud and share this mission. Established by the Big Innovation Centre in 2015, our project aims to devise policies to encourage firms to pursue long-run purpose, rather than short-run profit.

Our approach is based on large-scale academic evidence on how various practices work in reality that distinguishes causation from correlation, supplemented by practitioner expertise from companies, investors, consultants, think tanks, and policymakers.

In May we released an Interim Report on the benefits of a purposeful approach to business and proposed several policy reforms. Detailed reports on most of the proposals – such as promoting large and engaged shareholders, reporting intangible assets, and purpose certification – will be released early next year.

Read more: How to ensure companies invest for the long term

However, since the government has correctly highlighted executive pay as an issue to be fast-tracked, the Steering Committee released its Interim Executive Remuneration Report on Friday, which we hope will help inform how the government’s policy intent can be achieved. It contains several proposals.

First, to grant executives long-term equity. Evidence shows that, when a chief executive’s equity vests, on average she cuts R&D to pump up the short-term stock price. Long-term equity will deter such myopic actions. Indeed, studies show that chief executives with high equity holdings outperform their low-equity peers by 4 to 10 per cent per year. The effect of such grants is to tie the executive’s wealth to the long-term stock price.

Our Interim Report presented substantial evidence that the long-term stock price takes into account not only profits, but stewardship of employees, customers, and the environment – unlike the short-term price which can be manipulated. Indeed, evidence shows that long-term incentives cause firms to be more innovative and socially responsible.

While there is no one-size-fits-all solution, an optimal release period might be five to seven years (longer in firms where investment is particularly important). Critically, the release period should extend beyond the executive’s retirement, to encourage succession planning and investments whose payoff extends beyond her tenure.

Read more: Do bonuses encourage people to cut corners?

Second, to substantially de-emphasise long-term incentive plans or bonuses based on financial targets. Evidence shows that such plans can induce executives to take short-term actions to hit these targets.

Moreover, the actual targets the executive needs to hit are not always transparent to the public. Executives can underperform and yet still be handsomely rewarded, sometimes because they influence how performance is measured after the fact.

Third, to grant executives long-term debt-like claims (such as deferred cash compensation), the value of which is eroded in bankruptcy. Evidence shows that debt-like pay leads to lower bond yields and looser covenants – ultimately benefiting shareholders – as bondholders recognise that a debt-aligned executive is unlikely to take unnecessary risk.

The sum total of these first three measures is that pay will be simple – salary, equity, and debt – unlike the complicated formula-driven bonuses that abound nowadays. These components are also easy to value, and so it is transparent to the public how much the executive will get paid, and under what conditions.

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

Fourth, to launch a Fair Pay Charter describing how worker pay is determined – how it is linked to broader market conditions, how workers have benefited from long-term increases in company performance, and the relative movement of worker and chief executive pay. Moreover, companies should be required to consult workers on the Charter.

Creating this broader comparison and accountability is more effective than publishing a snapshot pay ratio, which may lead to misleading comparisons between companies (being lower in investment banks than retailers).

Workers should be paid fairly regardless of whether the chief executive is well-paid; a fall in chief executive pay should not lead to a fall in worker pay. Such a ratio may decouple pay from performance – the chief executive should only be paid if she has created long-term value, and keeping worker pay high is not an excuse for failing to do so.

Read more: UK bosses' pay packets soar but pay ratio narrows

Finally, to trigger a binding vote when a company fails to achieve 75 per cent support in its advisory vote two years in a row, as well as when a vote is lost in any year. This will ensure that the advisory vote has teeth.

We believe this is the best way to create stronger accountability through more binding votes because evidence suggests that, in nearly all cases, the advisory vote works. Companies receiving less than 80 per cent support improve their next-year vote by 17 per cent rather than ignoring it. Targeting additional binding vote requirements on repeat offenders will ensure that new regulation is focused on the cases that matter.

In an emotive area such as executive pay, basing policy on evidence is vital. The obvious answers aren’t always the right ones. The Purposeful Company Interim Executive Remuneration Report provides an evidence-based approach on how to reform pay to serve society.

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