The Advisors' Blog

– Broc Romanek, CompensationStandards.com

While I was on vaca last week, John Plender wrote the following column – entitled “To avoid a backlash, executives must act on pay” – in the Financial Times that I thought was noteworthy (note the internal pay equity ratios provided):

Richard Lambert, director-general of the Confederation of British Industry, drew attention this week to a very inconvenient truth: that the chief executives of the UK’s 100 largest companies will, according to Income Data Services, have earned 81 times the average pay of full-time workers in 2009. This is up from 47 times the average wage in 2000. While performance has no doubt improved at many of these organisations over the period, it is hard to see how pay increases on this scale could possibly be justified.

Yet this differential is dwarfed by that in the US, where the Institute for Policy Studies estimates that in 2008 top executives earned 319 times more than average US workers. That compares with the benchmark of 20 times that Peter Drucker, the great management guru, thought sensible. In both countries income inequality and corporate profits as a percentage of gross domestic product have recently touched their highest levels since 1929, a year in which the Jazz Age gave way to a financial crisis second only in historical impact to the one we have just experienced.

Meanwhile, another inconvenient truth has emerged at Kraft Foods, where chief executive Irene Rosenfeld was awarded a 41 per cent pay increase to $26.3m partly on the basis of her performance in acquiring Cadbury through a hostile bid. Given that a majority of takeovers fail to work and the widespread suspicion that Kraft could suffer a “winner’s curse” for overpaying, this looks objectively crazy.

It also suggests the Kraft board has learnt little from the banking crisis, despite having a compensation committee led by Ajay Banga, a banker from Citigroup. One of the big lessons was that rewards should be related to the period over which returns are earned and that, if upfront payments have to be made, they should at least be subject to a clawback.

All this comes against the background of a growing political backlash against bankers’ bonuses on both sides of the Atlantic. This may be populist, but it is based on yet another inconvenient truth. We now know that much of the profit on which bank bonuses were based before the crisis was fictional. Much of the phenomenally high return on equity that did exist arose from banks riskily shrinking their equity capital rather than boosting the return on assets.

At the same time, academics Thomas Phillipon and Ariell Reshef estimate that 30 to 50 per cent of the wage differential between the US financial sector and the rest of the private sector comes from rent-seeking – the economist’s euphemism for ripping off customers in opaque and inadequately competitive markets. This is probably also true of the UK.

Mr Lambert rightly fears that the hostile perceptions of a public that is paying for bank bail-outs will rub off on the wider business community so that wealth creation is damaged. Society’s tolerance for high levels of inequality is also being tested to destruction. In a country such as China, the current very high level of inequality is just about tolerable on the basis of real growth rates of 10 per cent or more. In debt-sodden developed countries facing years of low growth as balance sheets are rebuilt, the political consequences could be much more harsh. So where do we go from here?

Some natural corrective mechanisms are at work in both the political marketplace and the economy. High levels of profit will come down as anti-business sentiment prompts heavy-handed regulation and increased taxation, causing animal spirits to flag. It is possible that labour will win back ground relative to capital as rising living standards in Asia lead to a weakening of the downward pressure Asians have exerted on pay in the west. In finance, a return to more utility-style banking will mean less spectacular profits, while financial jobs will become less skill-intensive, complex and highly paid.

Yet huge increases in top pay regardless of performance represent, among other things, a failure of leadership. They also reflect a failure of accountability and stewardship. So if the boardroom pay ratchet is to be stopped, incentive structures and boardroom behaviour have to change.

Mr Lambert wants businesses to hold up a mirror to themselves and see how they look to the outside world. The trouble is that Lloyd Blankfein of Goldman Sachs has done this and found, notoriously, that he is “doing God’s work”. For others the problem is more that well-intentioned directors are locked in a procedural box, advised by pay consultants who are conflicted and using metrics that are flawed. Even where money is not the chief motivation, it is a race in which no chief executive wants to fall behind his or her peers.

Institutional shareholders, in the UK though not the US, have engaged in intensive dialogue with management on pay. They have done well in eliminating rewards for failure and improving incentive structures. Yet they have been unable to address absolute levels of compensation.

Breaking this vicious circle requires a catalyst. If business leaders and institutional shareholders do not address the conflicts of interest inherent in their respective positions more directly, there is a danger that government will.

The remedy of disclosure has failed, simply encouraging the ratchet effect. Boards must raise their game – but that in itself will not be enough. So maybe the time has come for institutional shareholders, with encouragement from politicians, to take a majority of the seats on remuneration committees, as they do in Scandinavia on nomination committees.

If business is not to suffer from a permanent legitimacy deficit, with all that that implies for the economy and society, something radical has to be done.