20 Feb 2017
Focus on failure to create societal benefit, says LBS professor
The growing public hue and cry over executive pay may have a point. But it is often misplaced according to the claims of one London Business School academic, who argues that the biggest issue is not that executives pay themselves too much, but that they all too often coast, failing to create wider societal value.
Alex Edmans, a Professor of Finance at London Business School, who has recently published his response to the Government’s Green Paper on Corporate Governance Reform, made the remarks writing recently in the Financial Times.
Professor Edmans said: “The level of pay attracts most public anger. It is easy to understand why — the average FTSE 100 chief executive is paid £5m, 178 times more than the average UK worker. If CEOs didn’t take so much for themselves, the argument goes; their slice could be reallocated to others.”
But this “fixed-pie mentality” is wrong, Edmans believes. And it misses a more fundamental point.
“The biggest way in which executives can take from society is not by paying themselves too much. It is by coasting and failing to create value for wider society,” Edmans explains. CEO pay should ensure that businesses serve society, not just executives, Edmans says. “The best way to do this is to incentivise the CEO to grow the pie for all,” he adds.
The median FTSE 100 company size is £7 billion. If a CEO creates 1 per cent extra value, that’s £70 million, which swamps any savings from reducing his or her pay. But the real question is does any of this increased value go to society?
“It does,” Edmans says. “Successful companies survive and grow, paying taxes, creating jobs, paying suppliers, and providing goods and services to customers — often for free. While the tech boom has created elites, it has also transformed everyone’s lives, giving us free access to search engines, mapping, online banking and shopping.”
Edmans doesn’t deny that executives must be held to account for errors of commission, such as unnecessary job cuts. But he argues that they should be held to greater account over the often overlooked errors of omission.
“These are much less visible, but far more destructive,” Edmans wrote in the Financial Times. “If executives coast, and fail to create jobs or launch products, the losses can be substantial. But the way that we vilify business encourages coasting.”
The answer Edmans claims, lies in pay reform that is focused on the structure rather than the amount of pay.
“Complex, opaque bonuses encourage myopic behaviour, such as investment cuts to meet short-term financial targets. Instead, pay should obey three principles: it should be simple, transparent, and long term.”
Long-horizon equity then could be the answer. It does just that – shares are easy to value and they depend on the long-term stock price. In the long run, the stock price captures value not just for shareholders but stakeholders as well. And, Edmans argues, evidence shows that granting CEOs long-term equity, means not only higher future profitability, but also innovation and stewardship of the environment, as well as customers, society and, in particular, employees.