What to do about 'fat cat' executive pay

Chief executives (CEOs) get paid a lot of money. That seems reasonable: they're the ones who make the big decisions and steer the company. Above all, they are responsible for delivering returns to shareholders. As they get rich, so do we. At least, that's the theory.

So how do we explain what's happened in the last 40 years? Has being a CEO got a lot harder? Or does the average CEO now deliver superior results? You'd think so from the numbers. As Roya Wolverson notes in Time, in 1965 the average CEO got paid 24 times as much as the average worker. By 2007 that ratio had risen to 275 times.

So have shareholders got correspondingly richer? Sadly not. To take just one sector, in 2010, the average pay for the CEOs of Europe and America's biggest banks rose by 36% to around $10m each, says CLSA banking analyst Mike Mayo. Yet "revenues across the board rose by less than 3%" and profits "varied wildly". And over the last decade, while average employee compensation at US banks has doubled, share prices have plunged (down 80% for the likes of Citigroup) and some banks have even vanished (Bear Stearns).

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Big bonuses are bad for business

The justification for big pay packets is simple: the more you pay someone, the harder they work. But Dan Ariely, a professor of behavioural economics, reckons this is simply untrue. In one of his studies, undergraduates were given the chance to earn a bonus of $600 or one of $60, based on their performance in a cognitive test (adding numbers) and a purely mechanical one (tapping a key as fast as possible). The latter task "worked as would be expected" the higher the pay, the better the results. But as soon as the task "required even rudimentary cognitive skill", the offer of a bonus "actually lead to poorer performance".

This is backed by real life' findings from the 1930s Great Depression. In 1936, the Harvard Business Review published a paper called Executive Compensation Compared To Earnings. The author, John C Baker, took 100 firms and looked at the percentage of earnings handed to top executives as pay and perks from 1928 to 1933. All firms did badly over the period. But those that "paid their executives relatively less did better than those that paid them relatively more". This was true for companies of all sizes, and across sectors. Baker's conclusion? "Those [firms] paying a high percentage of earnings secure less satisfactory results."

So if we've known for so long there's no correlation or perhaps even a negative one between performance and pay, then why are CEOs getting even more money now? Because there are too many groups with a vested interest in the system.

The headhunter problem

In a recent letter to the Financial Times, Peter Brown, chairman of Synergy Holdings, who has lots of experience in founding executive search and remuneration firms, sums this up: "The traditional model of about 30% of the first year's total remuneration encourages headhunters to push their candidates to have significant short-term cash or share bonuses" rather than packages linked to long-term performance. These "can then be included in the fees invoice".

So why don't big shareholders protest? As Wolverson notes, in the US "roughly two-thirds of all stock is owned by institutions" mutual funds, pension funds and the like. "Their interests aren't necessarily the same as yours." They don't "bridle at bad corporate behaviour because they end up paying a high price in time and legal fees to fight back, without gaining much from any resulting boost in the stock price". Besides, many funds make more money selling to companies than to individuals why rock the boat?

What can you do?

Unfortunately, individual investors have little influence over pay. But as a shareholder you are entitled to table an item at a firm's annual general meeting and then turn up. If more of us did this, then at least it would embarrass the worst offenders. Also avoid shares in sectors where things have self-evidently gone mad such as banking. Look at the directors' remuneration report (near the front of the accounts). Evidence that senior directors own a stake in the business is a good start it suggests their interests are aligned with yours (a rising share price). But look out for very short-term bonus incentives (anything paid in less than five years): as a shareholder you don't want the board taking decisions purely designed to boost the share price in the short term.

Let's look at an example. It is common to reward executives in, say, the telecoms industry, on measures linked to growth in EBITDA (earnings before interest, tax, depreciation and amortisation). This measure of profits is supposed to be closer to cash flow and less subjective than some others. But it also strips out financing decisions (interest costs) and any charge for capex (depreciation). The result? Such firms have borrowed heavily to expand their capital-intensive, fixed-cost networks. It's good for the executives because it boosts EBITDA. But the value added can be minimal you may get rapid market share gains, but this will come with very low profit margins.