22 Jul 2016
To the extent that executive compensation is a problem, it should be shareholders, not politicians, or employees, who fix it, a London Business School professor has said.
Alex Edmans, Professor of Finance, London Business School, made the comments writing for Harvard Business Review and City A.M.
Executive compensation has recently become a hot topic for winning the public’s approval in many politicians’ campaigns, including Donald Trump and Hillary Clinton in the US, and new UK Prime Minister, Theresa May.
“Politicians typically make two suggestions for pay reform,” says Professor Edmans.
“First, to cap, or at least force the disclosure of, the ratio of CEO pay to median employee pay. Second, to put pay packages to an employee vote, or as Theresa May suggests, put workers on boards.”
But there are three main problems with their proposed approaches, Edmans says.
First, while it’s the level of pay that captures politicians’ and the public’s attention, it’s the structure of pay which matters more for firm value.
“A common argument is that high pay has indirect costs – in particular, it incents CEOs to take actions that hurt society. However, there is no evidence that the level of pay actually has this effect.
“Research that I have conducted with Vivian Fang and Katharina Lewellen finds that in quarters in which significant equity vests, CEOs cut R&D and capital expenditure.”
However, despite these findings, “the electorate will be more impressed by a politician who proposes a headline-grabbing law to halve a CEO’s salary than a politician who extends the vesting horizon from three years to seven, even though the latter will have a far greater impact on long-term value creation,” says Edmans.
Second, the motivation to lower CEO pay is to reduce inequality, yet attempts to curtail pay through regulation may backfire, Edmans warns. A focus on pay rations could in fact increase inequality.
“A CEO might reduce his company’s pay ratio by firing low-paid workers, converting them to part-time status, or increasing their cash salary but reducing their non-financial compensation, such as on-the-job training and superior working conditions.
“A cap could also lead boards to focus on the “optics” of pay (e.g. a low ratio) and ignore more important dimensions, such as performance targets being long-term rather than short-term.”
Third, Edmans’ is sceptical of Theresa May’s suggestion of putting employees on boards or submitting CEO pay packages to an employee vote.
“An employment contract is an extremely complex issue and cannot be whittled down to a simple number such as a pay ratio, which the vote might focus on. It covers topics such as the optimal vesting schedule, the appropriate mix of stock vs. options vs. salary vs. pensions vs. bonuses, whether industry performance should be filtered out and, if so, how. Confused? Well, so might employees be, should CEO pay contracts be put up for a vote.”
Companies already have strong incentives to consult workers – without any need for regulatory intervention – and many often do, Edmans says.
“One of my own studies showed that firms with high employee satisfaction – for which employee communication is key – beat their peers by 2-3% per year. We want to push the message that employees and executives are in partnership – consulting the former is good for the latter.
“There’s a big difference between consulting employees and putting them on the board. Firms do market research consulting customers, but don’t put them on the board.”
The answer, Edmans says, is “to leave the decisions to the major shareholders, who have the expertise and incentives to get these decisions right.”
CEO pay comes straight out of shareholder returns. If the contract causes the CEO to take bad decisions, or demoralises employees and customers, then it’s the shareholders who suffer the consequences, Edmans explains.
“Unlike regulation, which is one-size-fits-all, shareholders can decide what the optimal pay package is for that particular firm.”
And progress is being made. There has been a substantial increase in shareholder power with 11 countries having passed say-on-pay legislation since 2002.
“We have also seen innovation in other dimensions of pay that are more important than ratios – for example, the lengthening of vesting horizons and paying executives with debt rather than just equity.
“When pay is inefficient, it is often a symptom of an underlying corporate governance problem, brought on by conflicted boards and dispersed shareholders. Addressing pay via regulation will solve the symptom but not the cause. Encouraging independent boards and large shareholders will solve the underlying problem. That will improve not only pay, but other governance issues.”