David Adams 2 Mar 2017 10:30am

Is there a better business model for executive pay?

As the executive pay argument rumbles on, David Adams weighs up the relative income of CEOs to staff and asks if there is a better business model

You may or may not approve of the suggestion put forward in January 2017 by UK Labour Party leader Jeremy Corbyn that a cap on individual earnings would help to reduce inequality in society, but regardless of political beliefs, it would be interesting to find out whether many economia readers are comfortable with current trends in executive pay.

The extent of pay inflation at the highest levels has been extraordinary. The UK thinktank the High Pay Centre dubbed 4 January “Fat Cat Wednesday”, because by 12pm that day someone earning the median FTSE 100 CEO pay in 2015, £3.973m, would already have earned the UK employee’s median salary of £28,200 (ONS figures). The pay ratio between FTSE 100 CEOs and the average pay of their employees is now 129:1; in 1998 it was 47:1. In the US, research conducted by the Economic Policy Institute in 2015 suggested that the ratio between CEO and average worker pay there was 303:1.

Even if the figures are skewed by a small number of particularly big compensation packages, it is clear CEO pay has been growing very quickly. Is this the best use of a company’s financial resources?

It is possible that in future more CEOs will emulate the few business leaders who have decided they earn too much in relation to their colleagues and have taken action to change things. The most spectacular example is probably Dan Price, CEO of a small financial services firm in Seattle, who announced in April 2015 that he would pay all his staff a minimum wage of $70,000, funding this move in part by reducing his own $1.1m salary to the same level.

In December 2016 the connection between high executive pay and strong corporate performance was questioned after a study commissioned by investment industry body the CFA Institute from the Lancaster University Management School revealed that although the median pay of chief executives at FTSE 350 companies in the UK increased by 82% in 13 years, returns on capital invested in those companies had risen by only 1%.

Excessive executive pay was also identified as a key issue in the UK government’s Department for Business Energy and Industrial Strategy (BEIS) Green Paper on corporate governance reform, published in November 2016. The paper sought views on proposals including publishing ratios between CEO and average employee pay in firms; establishing a senior Shareholder Committee to scrutinise remuneration; and improving the processes enabling shareholders to vote on executive pay.

But Richard Belfield, director of the executive compensation practice in London and part of the global practice team at Willis Towers Watson, suggests that higher pay for senior executives in comparison to typical pay for workers is a trend in many countries.

He points out that North American CEOs tend to earn more than most European CEOs; and suggests that, within Europe, CEO pay in the UK, France and Germany is generally similar.

The big change in recent decades, Belfield suggests, is the way reward packages are structured. Many UK companies are likely to have a more diverse collection of shareholders, including institutional investors, therefore UK CEO reward packages often include share-based incentives, as, in theory at least, this increases alignment of shareholders’ and executives’ interests.

UK CEO rewards packages include only 25% in fixed remuneration, compared to 41% in Germany, 47% in the Netherlands, 59% in Sweden, 65% in France and 67% in Belgium, according to the findings of the Vlerick Business School’s 2016 CEO remuneration study.

Xavier Baeten, professor of management practice and founder of the Executive Remuneration Research Centre at Vlerick, describes some of the different factors that can influence remuneration strategy. They include the prevailing governance model in a country or an industry. For example, UK firms are heavily influenced by a capital markets-based business model, while in France and Belgium more companies are likely to still be controlled by majority owners. CEOs in firms where there is no majority owner arguably have greater power than those where there is, which may also help to drive up the value of their compensation packages. Local legislation can play a role too: if a country’s tax rules incentivise use of shares within a package, or if legislation limits bonus payments, as in the financial services industry in the Netherlands, for example.

In written evidence submitted to the BEIS Select Committee, ICAEW noted the impact of globalisation and increased executive mobility on levels of executive pay. It suggested there might also be some inflationary impact as a result of the use of executive pay consultants by executives to represent their interests to remuneration committees.

The ICAEW evidence recommends that remuneration committees “take whole-company and cross-company perspectives when it comes to pay so stark anomalies are highlighted and either remedial action is taken or rational justifications are discussed and agreed”.

But the Vlerick data suggests that the most significant factor of all is the size of the company. Baeten sees some logic to this, in the sense that bigger companies are more complex, but adds: “A CEO at a big listed company earns many times more than the CEO of a small listed company. I think they should earn more, but should the gap be that big?”

Another key concern expressed in relation to executive compensation packages is that a greater use of share-based incentives may encourage short-term behaviour – and a reduction in the average length of tenure seen in recent years compounds this effect.

Belfield isn’t so sure these factors are that significant. For a start there are many examples of CEOs staying in posts for a long time, including some of those at the top of the pay league. And although average tenures have fallen, he says, this is not usually down to CEOs jumping ship, but instead to boards acting, often driven by shareholder sentiment. The current levels and structure state of executive pay packages are, he concludes, the result of “a market outcome”.

Those less sanguine about that outcome, such as the High Pay Centre, suggest that publishing the pay ratio between the CEO and the average employee, as proposed in the UK government Green Paper, might help curb excessive generosity on the part of the remuneration committee. The High Pay Centre also advocates elected employee representatives sitting on remuneration committees (remcos).

“We propose having employee representation on the remco because we believe the conversations there are not sceptical enough,” says the High Pay Centre’s director, Stefan Stern. “You need the voice of the employees on there – at least two representatives, properly resourced. I think that would change the nature of many of these conversations.”

In its evidence to the BEIS Select Committee, ICAEW warned that limiting executive pay to multiples of the pay of junior employees could “have unintended consequences – eg companies with large, low paid workforces may outsource”.

Stern does not accept that the current state of affairs is simply a market outcome. “It’s not a market that’s operating normally,” he says. “Shortlists are very short. People demand big packages and get them. That’s not a competitive market.”

There is some evidence that CEOs are driven by a more complex set of motivations than mere financial gain. When researchers at the Vlerick Business School asked 950 CEOs in the Netherlands and Belgium how satisfied they felt in relation to a series of issues, including pay, but also matters such as relationships with colleagues and the extent to which they travelled for work, the results showed CEOs were most driven by non-financial reward satisfaction, such as pride in their work, working for a company with high ethical standards, and success overcoming challenges. The second most important motivation was ambition. Other factors, including pay, were seen as less important.

“If you look at what really drives CEOs, it’s about the challenge and about whether they are proud to work for an employer,” says Baeten. “If they compare themselves with their peers they don’t ask to be paid more than them but to be paid fairly.”

Almost two years after cutting his salary in order to equalise pay within his company, Gravity Payments’ Price thinks more executives will eventually follow his lead.

“The new breed of CEO will seek fair income to support their life goals, families and other expenses,” he says, “but then they will want to forget about money and drive towards success as they choose to define it.”

If he is even half right, many corporates across the world could stand to make some huge cost savings in the years ahead. But, whatever reformers and politicians say, for the time being the power of the remco remains undiminished; and many of those who sit upon those committees seem convinced that when it comes to the CEO, it is worth paying more today in search of greater success tomorrow.

The big pay deals

Recent controversy over high pay included a shareholder revolt at BP in spring 2016, where 60% of investors voted against the £13.9m pay package being offered to chief executive Bob Dudley despite the company having made record losses in 2015. Dudley was unabashed, telling The Daily Mail that his salary and bonus had both fallen from the previous year. It would certainly have been interesting to be a fly on the wall for the remuneration committee’s deliberations.

But Dudley’s compensation package puts him nowhere near the big league in terms of CEO wealth. The best paid CEOs in the world include:

Patrick Soon-Shiong, CEO of biotech company NantKwest, a South African-born entrepreneur, was paid $132.2m in stock options and $15m in restricted stock in 2016 after taking NantKwest public. He met with the then US president-elect Donald Trump in November 2016 to discuss the future of medicine and may resurface again as an adviser to the new president.

Joe Kiani, founder and CEO of medical technology company Masimo ($119m).

Michael Fries, president and CEO of US telecom giant Liberty Global ($111.9m in 2014).
Sir Martin Sorrell, CEO of advertising firm WPP ($103m, plus additional stock rewards), usually referred to as the best paid CEO in the UK.

Denise Coates, founder, majority shareholder and CEO of Bet365, thought to have been paid £117.5m – £54m plus £63.5m in dividends (or about $142m for the total package) in 2015. As a trained accountant, Coates topped economia’s 2016 Accountancy Rich List.

Sundar Pichai, Indian-born CEO of Google ($100.5m in 2015, plus $199m of shares that will vest over three years)

Man of the people

Dan Price is CEO of Gravity Payments, a credit card processing company based in Seattle, on the west coast of the US. In April 2015, after a hiking trip with a friend who was struggling with her finances, Price had an epiphany.

He announced that over the following three years the salaries of all 120 Gravity staff would rise to a minimum of $70,000. For 30 employees the increase represented a 100% pay rise.

The announcement certainly raised the company’s profile. Donald Trump called him “a joke”; he was lambasted as a lunatic and a socialist by right-wing media commentators; while the then Democrat presidential hopeful Bernie Sanders said Price was setting an example from which others should learn.

Price is proud of the diverse ways members of staff have benefitted as a result of the change: many have moved to better accommodation closer to the office, bringing them benefits in their non-work lives, but also increasing productivity in the office. “We’ve saved a total of 1,560 hours in commute time just in the past year,” says Price. “Our profit has nearly doubled and our client attrition rate is at an all-time low.”

There were some problems: two members of staff resigned because they thought it unfair that others, who did not have as much to offer by way of expertise, would be earning the same as them.

There has continued to be some unfavourable media coverage by those opposed to Price’s way of working – a section of the company’s website aims to rebut such claims and to act as a hub for interaction with anyone who wants to learn from Gravity’s pay policy.

Asked if he thinks it would be beneficial for other companies – or even for national economies – if the difference between most CEO salaries and those of their colleagues were smaller, Price has no doubts.

“Paying [employees] more results in less distraction, greater autonomy, higher capability and ultimately better business outcomes,” he says. He names a number of major employers that have increased wages significantly during the past two years, including JPMorgan Chase and Ikea, and seem to be enjoying increased productivity and lower staff turnover as a result.

“It’s my honest belief that imposing a $70,000 minimum wage will improve the success of our clients,” says Price. “I did this for the Gravity Payments’ team who sacrifice so much to make our clients’ lives easier.

“I would like to be a speck of sand in a revolution that fundamentally changes the purpose of business. I want the focus of business to move away from financial engineering and greed, towards solving some of the greatest problems facing society. As a leader, I needed to take bold action. Other business leaders need to recognise you can pay a living wage and still manage to thrive. We have a moral imperative to do our best for those we’re leading.”