Wednesday, 20 June 2012

Executive Pay

So the government is going to introduce binding votes on pay. This is part of what has been referred to as a "Shareholder Spring" of recent years, which has seen shareholders vote against the remuneration packages of various large firms.  However, to date, these votes have been merely advisory.

I have to admit, I was truly gobsmacked when this proposal was first aired a few months ago. I am incredulous that it has ever been the case that shareholders’ votes on remuneration packages for senior management are only advisory. But then, that is what comes of being a theorist.  We know how these things are supposed to work, but are often surprised by what turns out to be "custom and practice".  

There is certainly a problem with executive pay. Over the last few years, executive remuneration has risen by around 50%, with no concomitant increase in corporate performance. It is too easy for executives to be rewarded for failure just as they would be rewarded for success. This may in part explain the poor performance of some firms over the past few years.

Nevertheless, when it comes to corporate pay, as the bard would say: “The fault, dear Brutus, lies not in our stars, but in ourselves...”

Given the shocking state of affairs, we should perhaps recap the relationship between managers and shareholders. What is the relationship supposed to be in theory, and what has happened in practice?

In theory, the manager is the servant of the shareholders. Think of the Earl of Grantham and the Butler, Carson from Downton Abbey. The shareholders do not have time to run the company that they own themselves. Even if they did, there may well be people who can do a better job of it than they can. The shareholders and the manager are both better off if the shareholders hire the manager to manage their firm. The manager gets a salary and the shareholders get the profits.

In practice things seem to have developed quite differently. Managers seem to have gained control of the firms they are running. To continue with the analogy, Carson is now upstairs being dressed by the Earl of Grantham. How has this happened? The answer essentially lies in the strength that comes from being one of a small number.

Think of the profits of the firms (before executive salaries are deducted) as a resource over which management and owners compete. A solution is negotiated between the two parties and the shareowners then have their say (which is not currently binding). Our experience of arguments and debates might lead us to expect that the group with the largest number will win more out of these negotiations. However we would be wrong. Indeed the greater number of shareholders is precisely what gives the managers the decisive advantage.

Among the shareholders, informing themselves about all the issues surrounding the executive pay within their firm and arguing about those issues with the management are costly actions. It takes a lot of time to find and understand all the numbers. There is a reward in higher dividends, and the total reward may well outweigh the cost, but that reward is dispersed across all shareholders. Remember that if a shareholder has sensibly diversified their portfolio, then they would ideally be doing this for a large number of firms. However the benefits of these activities are spread across a large number of shareholders.

Corporate governance activities are what economists would call a public good. The benefits are “non-rival” (one shareholder’s consumption of the benefit does not stop another shareholder from consuming the benefit) and “non-excludable” (it is impossible to exclude one shareholder from the benefit without excluding all). Corporate governance is like the washing up in a shared house. Everyone benefits if it is done, but no one actually wants to do it.

This is a problem unlikely to solve itself and only likely to get worse! In an egalitarian capitalist society, the ownership of capital should be widely dispersed. More people should own fewer shares.  But this will worsen the corporate governance problem and allow managers to get higher and higher remuneration which becomes less and less responsive to performance. As we get more shareholders, the benefits of exerting corporate governance become more dispersed.

The question then becomes what should be done. Giving shareholders a binding vote on remuneration is certainly a start, but the government may need to go further than this. Managers enjoy the privilege of “agenda control”, meaning that they would still get to decide what precise package the shareholders are voting on. A binding shareholder vote might simply become a costly veto where the shareholders face a choice between approving a pay package, or plunging the company (and its stock price) into uncertainty by wielding a veto. Shareholders should be choosing between two alternative remuneration packages, one put forward by management and one put forward by shareholders. The shareholders should also perhaps hold a vote to decide which package they put forward to compete with the management proposals.

The measures to increase transparency also provide a good start. What is needed is a way to ensure that when shareholders vote they are conscious that every penny they pay the chief executive is a penny less in dividends for them.  Simple reporting of total pay should help to raise this awareness.  Although I remain skeptical that managers will find ways of muddying the water here; probably through bonuses or shares issued as bonuses.

These are all measures that will make it easier for shareholders to re-assert control over their companies. However even these measures might still prove insufficient. Shareholders will still be blighted by what economists call a “common action problem”. Common action problems such as this can be resolved by the parties themselves, after all, they are the people with the biggest incentive to solve them. Better information and voting structures will help, but if they do not allow shareholders to solve the problem, other reforms to corporate governance measures may prove necessary.


  1. What about executive pay in all those organisations in the public sector where there are no shareholders and no dividends?

  2. I have to admit to not having much data on that, but I should imagine that the reason chief executives in public sector organizations have seen their pay increase is that public sector organizations have to compete with the private sector for their labour services. So once private sector pay comes down, public sector pay should follow.