This is the year that top executives will start to feel the squeeze

published 23 January 2017

17-1-23-Corbyn-1200 — Jeremy Corbyn's proposal to cap salaries is a silly idea

Chief executives get paid too much money, and in ways that often incentivise them to destroy, rather than create, shareholder value.

That's not a controversial statement. (You will have no doubt noticed that we are hardly Corbynistas or rampant Piketty acolytes here at MoneyWeek.) It is simplyabout as close to an objective fact as you can get with any question that involves other people's wages.

The trouble is, a lot of these objective facts get mixed up with politicised nonsense to create stupid "solutions" like Jeremy Corbyn's abortive idea of capping wages. These sorts of measures invariably miss the real targets and create even more distortions and mal-incentives in an already messy system.

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The good news is that, in the background, one very powerful force and one that has little to do with populism or politics is already gearing up to squeeze pay packets at the top of the food chain.

The power of competition.

How passive investing is set to drive down CEO pay packets

the growing popularity of passive funds

Passive asset management giant BlackRock had just written to every FTSE company chairman, warning that they'd be taking a much stronger line on executive compensation.

At the end of the day, investors use tracker funds and other passive vehicles because they are keenly aware of the importance of costs. They don't want to get ripped off by a fund manager who poses as active but in fact, is just a closet tracker.

The passive industry is also highly competitive. For now,Vanguard and BlackRock can gobble up customers from the active sector. But increasingly, they'll have to compete hard with one another for business. That means finding ways to stand out.

One way to do that is by promising to stand up for their investors' interests even more effectively. They have already positioned themselves as the champion of the small investor against the active management industry.

So the next logical move forbig passive asset managers who want to keep attracting new business is to help drive down other costs that ultimately come out of shareholders' returns. The most high profile of these is egregious executive pay packets.

It's true that passive funds have to hold onto the shares they own. So they don't have the ultimate sanction of being able to sell out of companies that refuse to tackle their concerns on pay.But you could also argue that being forced shareholders means that they have all the more incentive to make sure that the companies they have to own are well run.

And in any case, the political climate is turning against overly generous executive compensation and the systems that encourage it. If some of the corporate world's biggest shareholders are seen to be constantly voting down pay packets yet being ignored by senior management, then you can expect governments to step in.

So that's one way in which competition could help to drive down executive pay.But there's another key factor also connected to the rise of passive investing raised in the FT this morning. It's the fact that active fund managers are starting to struggle on the pay front themselves.

A hard way to earn a crust

Now, of course, fund managers still get paid a lot. And this is an average across the industry. But there aren't that many industries in the world today where pay has actually fallen (and not just in "real" terms) over the last two years.

What's going on? Obviously here have been lots of high-profile criticisms of pay in the fund management business. But that's nothing new. Talk is cheap, and all the talk in the world won't shame your average man or woman into taking a hefty pay cut to their own salary.

What it really boils down to is that investors now have alternatives to active managers and they're using them. And that means there just isn't as much money to go round to pay for expensive staff.

The passive industry is absolutely hammering the active side. According to Morningstar, in the US in 2016, investors pulled $340bn out of active funds. They invested all of that, plus another $165bn on top, into passive funds.

A fund management company (active or passive) makes its money by scooping up as much cash as possible from investors, then keeping a healthy percentage of said cash for itself.When it comes down to the bottom line, the performance of its funds only matters inasmuch as this assists with marketing the group, and attracting more money into the pot.

But the effectiveness of active managers as asset-gathering operations has been severely compromised by the rise of the passive investment industry, and (in the UK at least) the liberation of financial advisors from the shackles of a commission-based fee structure.

Hence the pay cuts.

If I'm not getting a double-digit pay rise, then neither are you, sunshine

When everyone's boat is rising on a tide of money, it's easy to wave away something that might look a tad excessive, particularly if it raises uncomfortable queries about your own pay packet.

But if you can turn around and say that your own compensation has gone down well, it's much easier to start lobbing stones.

Also, if your job suddenly depends on being a much better custodian of your clients' capital than the great big passive fund manager down the road, then maybe you'll be inclined to think of yourself as being on your clients' side.

Maybe you'll start to think about the long term more. Maybe you'll care about getting value for money from the people running your company. Maybe you'll start to question whether slashing investment in a critical area of the company and taking a hefty pay rise for doing so is actually in the best interests of the owners.

So rather than acting like one big happy, well-paid family, owners' representatives will start acting more aggressively to hold managements to account. No pay caps necessary.

Here's hoping.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.