What goes up must come down: analysing the forces that drive executive pay
25 March 2014
For proof that the world can change in unexpected ways, those concerned about executive pay need look no further than a 1976 Harvard Business Review article by David Kraus. Entitled 'The 'devaluation' of the American executive’, he bemoaned the fact that the relative decline in executive pay experienced over the previous decade was “probably here to stay”.
Such sentiments might seem bizarre today given the doubling of UK executive pay since the millennium, while average earnings have increased by only 10% in real terms. But equally when Kraus was writing, would anyone have thought that within a decade the great executive pay inflation would be underway?
Bonuses paid to FTSE100 chief executives have fallen in each of the last two years and salary freezes have become commonplace. Many believe this is simply a blip and the relentless upwards trajectory of executive pay will resume once the economy recovers. In my view, this is unlikely. Executive pay seems likely to stagnate in real terms, a decline is even possible as the forces that drove executive pay up abate or go into reverse.
One of the often quoted reasons for executive pay inflation in the UK is companies trying to keep up with their global competitors in the war for talent. I believe the globalisation of pay levels has now run its course. Research shows there is now significant convergence of pay levels globally, with pay declining in the US as it has risen in Europe and emerging markets. International benchmarks are no longer an inflationary force.
Another factor driving executive pay was the increase in complexity. Following the Greenbury Report in 1995, companies introduced new long term incentive plans alongside existing share options. By 2004, four out of five FTSE-100 companies used at least two long-term incentive plans, and one in five used three. But complexity has back-fired. Our research with the London School of Economics and Political Science shows that executives drastically discount complex pay packages and would be happier being paid less in a simpler more certain form. The revolt against complexity has already begun in the UK and we already see examples of pay coming down as it simplifies.
In some cases, pay benchmarks are starting to come down. As the attraction of the ‘star CEO’ has waned, companies are investing more in succession planning. Three quarters of CEO appointments in the FTSE-100 are now internal promotes. Over the last year these CEOs have been appointed on a salary 13% below their predecessor on average. This trend is likely to have a sustained dampening influence on executive pay. Benchmarking has been blamed for ratcheting pay, but it simply accelerates trends. We could now see benchmarking acting as a brake on pay.
Finally, there is no doubt regulation has a role to play. Research shows pay in financial services tends to be inversely correlated with the intensity of regulatory intervention. As banking was deregulated, a pay bubble formed with spill over effects across the economy. The current regulatory focus will put this into reverse. Pay in investment banking has already fallen by nearly 40% relative to pay in the general economy and further falls are expected over the next decade.
Over the last 35 years the share of profits in GDP has grown relentlessly at the expense of wages paid to labour. And as the share of profits grows, so does executive pay. But what goes around comes around. Just as 1976 turned out to be a high water mark for wages as a share of GDP, so 2013 could turn out to be a high point for profits (and hence executive pay). With the post-war gains for labour now reversed, surely the likelihood is for a correction, or at least a plateau.
Who knows what surprises the future holds, but we shouldn’t assume things will carry on as now. And lessons for policy makers? The world often changes in unexpected ways, whether executive pay goes up or down will to a degree be determined by forces beyond the ability of governments to shape.
To read our full analysis of the future implications for executive pay, you can download the report here. And if you’d like to discuss any of the points raised, please do leave a comment below or get in touch.