Taking the lid off CEO pay

Those who claim bosses' salaries are out of control miss the point: their rampant inflation is part of the ideology of shareholder value. How did we allow this to happen and what can be done to bring their remuneration back down to earth?

by Simon Caulkin
Last Updated: 23 Mar 2016

Fortune called it 'the great CEO pay heist'. 'Executive compensation has become highway robbery,' it fulminated. 'We all know that.' Consultant and high-pay critic Graef Crystal entitled his book In Search of Excess, in ironical homage to Peters and Waterman's ground-breaking volume In Search of Excellence. A modern CEO, he wrote, was 'a cross between the ancient Pharaohs and Louis XIV - an imperial personage ... who is paid so much more than ordinary workers that he hasn't got the slightest clue as to how the rest of the country lives'.

The most noteworthy thing about these publications, even more than the amounts of money they describe, is their date. The Fortune article was published in 2001. Crystal weighed in on 'the overcompensation of American executives' a decade before in 1991. After a further 11 years of uninterrupted CEO enrichment in which the differentials between the 1% and the rest of us have widened from River Thames to Grand Canyon proportions, the questions that the Fortune article posed - 'How did it happen? And why we can't we stop it?' - take on redoubled resonance and urgency.

Actually, the answer is simple: the metaphorical elephant in the room that is so big no one can see it. CEO pay isn't out of control at all, just the opposite. It goes up in the same way that an up escalator goes up, because that's what it is designed to do. 'Do you believe in a market economy or don't you?' asks John Purkiss, a principal at search firm Veni Partners. Of course, no one expected pay to turn into a Frankenstein's monster, trampling all over the system that created it. But the fact is that soaring CEO pay is the logical outcome of changes in the way Anglo-US companies are run - changes that were deliberately introduced in the 1980s.

They were designed as a kick in the rear to complacent managers who seemed more interested in empire-building than attending to shareholder interests. It seemed simple and elegant. If managers were feathering their own nests at the expense of shareholders, the rightful owners, the argument ran, the remedy was to change the way they were paid. Instead of a steady salary, at least some of their pay should be equity-based - for example, in the form of stock options - so aligning their interests with those of shareholders.

Incentives change behaviour - that's the point. But 'be careful what you wish for' was never an apter adage. The result has been the reverse of the one intended. 'Shareholders have done worse out of shareholder value than they did before,' points out Richard Lambert, previously director general of the CBI and a former editor of the Financial Times. 'The worthy alignment of CEO compensation with shareholders has had the perverse result of harming shareholders' interests.'

The cause may be the most destructive working out of the law of unintended consequences in human history. 'In the 1980s,' recalls Damien Knight, a principal at remuneration consultants MM&K, 'boards were very sensitive about giving themselves raises. They took care to wait until negotiations with the workforce were completed and often awarded themselves less.'

How quaint. That world came to a juddering end when, to initial bemusement, managers found themselves being instructed that self-interest was not only acceptable, it was expected behaviour in the service of shareholders. The reversal was abrupt and complete. Whereas in the 19th century, notes the Bank of England's director for financial stability, Andy Haldane, in a widely noticed article in the London Review of Books, 'managers monitored shareholders who monitored managers ... in the 21st century, managers egged on shareholders who egged on managers'. As they were supposed to, managers grabbed the opportunity with both hands.

Haldane's subject was the banks, but his analysis holds for Anglo-US capitalism generally. The resulting settlement, he points out, mightily benefits managers and shareholders in the short term, but short-changes everyone else. In the case of the banks, the 'hugely powerful' pecuniary incentives to managers to jack up shareholder value helped fuel the flow of flawed and ever more complex financial products, and vastly amplified the leverage that together gave the world financial system a near-death experience in 2008.

In the non-financial sector, the effects of governance based on 'equity dictatorship' (Haldane's phrase) were more gradual but just as debilitating. It is no exaggeration to say that they reshaped the UK economy. Responding enthusiastically to their new incentives, managers abandoned previous 'retain and reinvest' strategies (broadly, using retained profits to invest in expanding the business, benefiting all stakeholders) in favour of shareholder-focused 'downsize and distribute' - slashing headcount, outsourcing functions and selling off non-core businesses to boost return on equity. Instead of reinvesting, they distributed the profits via increased dividends and above all burgeoning share buybacks, which in some cases exceeding 100% of profits. Downward pressure on ordinary wages, aided by globalisation, was relentless and R&D was slashed. Unsurprisingly, the innovation rate has slumped since the 1980s. Pensions (at least at lower levels) are a further casualty of CEOs' single-minded drive to meet shareholder-return targets.

The flip side, of course, was managerial salaries. By aligning themselves with external shareholders, CEOs broke the link with their own employees. Without that restraint, salaries were free to soar. While ordinary workers were assumed to be motivated by the job, it seemed that the inhabitants of Planet CEO needed ever more lavish inducements to get up in the morning. The US led the way. In 1980, the average ratio between a CEO and the median salary of a US worker was 40 to one. In 2010, even with levels falling from the peak, it was 325 to one. In the UK, following the US at a discreet distance as usual but now catching up, the average FTSE 100 CEO pay packet of £4.2m was around 150 times the average salary compared with 20 times or less 30 years ago. On present trends, the multiple will hit 214 times by 2020.

The cult of the heroic CEO, enthusiastically promoted by a worshipping business press, fed lucratively into the process. 'A big piece of the story is the lionisation of the CEO by the press,' says Stanford Business School's Professor Jeff Pfeffer. 'If you're hiring a saviour, no amount of money is too much.' Never mind that there is precious little evidence linking leadership to organisational performance. By one estimate, up to 75% of performance is attributable to industry effects and economic changes. By another, 70% of stock market gains are due to market movements rather than performance. Crystal estimated that just 5% of a firm's performance was down to the efforts of the CEO.

'Half of it is luck,' acknowledges MM&K's Knight. 'CEOs are probably worth less than boards think'. Sums up Lambert: 'There is no economic reason why the multiple should have increased in the way it has.'

Hence the outrage: it's not just that bonuses for top managers were surging in good times and bad while ordinary employees suffered, it was the dawning sense that the two were directly linked: to some degree, the bonus depended on inflicting suffering. Few top executives, business writer and consultant Peter Drucker told Forbes in 1997, 'can even imagine the hatred, contempt, and even fury that has been created - not primarily among blue-collar workers who never had an exalted opinion of the "bosses" - but among their middle management and professional people'.

So where do we go from here? Stratospheric CEO pay is not universal; predictably, it is largely a phenomenon of big US, UK and international companies, most obviously in finance, whose governance is based on similar thinking. The upward pull has also washed over into the public sector, notes Bob Bischof, the Anglophile chief economic adviser to German Industry UK, and to some extent mid-sized companies too, although these are much less prone to excess, precisely because their members live on the same planet and face each other every day.

Indeed, once tendentious headlines are disregarded, estimates Sarah Wilson, chief executive of Manifest, a corporate governance research and advice unit, the situation in the UK is not as bad as it sometimes seems. The 'crony capitalism' jibe is less justified than in the US, where shareholders' rights are weaker and those of incumbent executives stronger. There are 'pockets of problems' and some executive packages seem designed to cause outrage, but 'companies have listened to shareholders', she insists. More work on simplification, disclosure and tying pay to a bundle of measures rather than crude shareholder value is what shareholders want to see, she adds.

Purkiss at search firm Veni agrees that it's 'astonishing' that the criteria for bonuses are so often confidential, but warns fixing the market because people don't like the outcome is likely to be counterproductive. 'We ought to call a spade a spade,' he says. 'A lot of this is about envy - and the last time I looked, that was a sin.' Big-company pay is set by global markets, of which the UK is a tiny part. 'If you believe in a market economy, you have to let salaries be set by the market,' he maintains. Distribution and fairness are better tackled through other measures, like education.

That's the feeling of many who think the Government's reaction to national outrage at the special case of the banks is panicky and over the top. 'Better sacrifice a goat,' said The Economist sniffily. Yet many others believe that this time is different. 'The Government has to act - and that's a good thing, because people are really angry,' says Lambert. The head of steam generated by the recent report of the (unofficial) High Pay Commission surprised even its chair, Deborah Hargreaves, who notes with satisfaction that its recommendations have been adopted by both the Labour party and, at least in principle, by the Coalition. She believes the Government's reaction is 'a good first step' but that 'it needs to go a lot further' - in particular with radical simplification of incentive design and reform of remuneration committees to include employee representatives. Even the Institute of Directors is supporting government action on the grounds that 'the pace of increase in executive pay is unsustainable'; the legitimacy of UK business is being harmed by pay packages that bear little relation to company performance, it frets.

Will the measures work? The commonest view is that they will have some effect at the margin, but the central drive is too strong for them to do more than slow the process down. 'Under capitalism as we know it, I don't think it's stoppable,' says Knight at MM&K. On the contrary, he calculates that with CEO pay accounting for just 0.27% of shareholder value created over the past eight years, there is still plenty of leeway for increase. Binding votes will make little difference. With the percentage so infinitesimal and the potential leverage so great, why should shareholders nitpick about a million here or there to keep a valued chief executive happy? Similarly, he thinks that sharing information - transparency, in other words - just keeps the ratchet clicking upwards.

Pfeffer agrees. To imagine that disclosure of pay levels will be a deterrent ignores everything we know about social psychology, he scoffs. 'X gets that? I'm worth at least double!'

Time, then, to look the elephant in the face. If after 30 years of tinkering the system still can't be made to work, there's something wrong with the initial premise. It's time to accept that both its central elements are fundamentally flawed. Researchers have been saying for years that pay for performance is a snare and a delusion, because the reasons for high performance can neither be isolated nor realistically linked to actions the CEO should be taking. In the FT, Lambert argued forcefully that the whole project is counterproductive, distorting executive behaviour, undermining intrinsic motivation and inciting risk. 'Is it right to think that senior managers are only driven by money and if they don't get what they want they'll go somewhere else?' he queries. 'I don't think so. And if they are, is that who boards really want to run the company?'

The ideologically motivated experiment of using pay to align top managers exclusively with shareholders (Haldane's 'equity dictatorship') has also failed. Three decades of turbocharged managerial incentives have tugged both companies and the economy out of shape. Rebalancing them, Bischof argues, necessarily involves rebalancing the pay structures that did the damage. For this, managers need to be reconnected (aligned, even) with their own employees and customers, who create the underlying value in companies, not shareholders.

This sounds like a daunting change, but it's not. It happens in the German Mittelstand - and it could do so here. All we have to do is use UK company law as the basis for pay governance rather than an ideological doctrine formulated in Chicago. In UK law, although directors are bound to have regard to the interests of shareholders, their only direct duty is to the company itself, to maximise its value for all its members, over time. Self-evidently, that doesn't include creating 'hatred, contempt and fury' among a company's workforce - indeed, that would probably be a breach of fiduciary duty.

Giving due weight to all stakeholders, on the other hand - which is the only way of doing what the law requires - would certainly make CEOs poorer. But shareholders, workers and society would be a whole lot richer as a result.


Under proposals put forward by the Government in January, shareholders could get binding votes on executive pay and golden handshakes, as well as the ability to claw back payments if company performance falls badly short of expectations. The Government is also proposing measures to make pay easier to understand and compare, break up cosy cliques on remuneration committees, and encourage major businesses and investors to lead by example.

In outlining his ideas, business secretary Vince Cable noted that organisations including the CBI, the Institute of Directors, the Association of British Insurers and the National Association of Pension Funds had all acknowledged that the current situation was unsustainable.

Unlike other approaches, the measures to enhance shareholder powers require consultation and legislation; if they all go through, they will constitute the biggest shakeup of pay reporting and setting for decades.

Under the new rules, companies will have to explain the performance criteria for executive bonuses - currently shrouded in mystery - and make clear to what extent and effect they have consulted with employees. As well as justifying amounts both past and projected, they will also have to explain how pay structures reflect and support company strategy.

Alongside greater disclosure, Cable wants to open up remuneration committees to much more diverse membership and end the practice of serving executives sitting on the remcos of other large companies. To confront potential conflicts of interest, he wants more openness about the role of remuneration consultants, which would include how they are appointed, who they report to and advise, and how much they are paid.

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