Cashing Out

Should we have a big debate about executive pay? Ross Gittins thinks so. Fred Argy thinks so too.

Australian Financial Review, Letters, 25 November 2005

Executive remuneration has become a very sensitive issue in the present industrial relations climate and it is not surprising that business leaders and their associations are seeking to justify the big increase (16%) that company chief executives have received over the last 12 months.  But it won’t wash.

Sure, company profits have increased markedly in recent years. But if recent national productivity data is taken at face value, the increase in profits has been due only marginally to improved managerial efficiency. Instead one can surmise that it has been due to four other factors. Firstly, many companies have enjoyed windfall gains from sharply rising commodity prices (with the compliments of China). Secondly, employees are being driven harder and expected to bear more of the normal business risks (witness Qantas’ recent demands on its workers) – a trend which will accelerate after the new workplace reforms are in place. The third source of increased profits has been the transfer of costs to consumers – who now have to wait longer on queues and telephones to get served.  And fourthly small suppliers and contractors are being mercilessly squeezed.

Many of these factors involve luck or externality costs for the rest of the community. So how do they warrant double digit increases in executive remuneration each year? Are CEO’s really creating wealth or just shuffling it around?

Fred Argy

I’m probably more sanguine than most progressives – including Fred – about the rise in CEO pay in the past 20 years. We know from a bunch of reports back in the 1970s and 1980s that the average quality of Australian CEOs was pretty bad, which was why we tapped into the global market for English-speaking CEOs. But to the extent that a wider income distribution imposes a negative externality on the rest of us, we clearly need to balance CEO quality off against the social cost of rising inequality.

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6 Responses to Cashing Out

  1. There is a pretty simple reform we could introduce here, which is to remove the requirement that annual reports include remuneration of senior management. The original view that including this information would prompt greater accountability on the whole has not happened – the main people who matter, the institutional shareholders, don’t care enough about this to put pressure on boards to keep salaries down. However, CEOs have used this info to pressure boards to pay ‘competitive’ salaries.

  2. Andrew Leigh says:

    But surely compensation committees would still find out the information? I thought you were going to make another argument – that if inequality makes us sad, ignorance about CEO pay must be bliss.

  3. A friend who worked in the BCA maintained that the publication of salaries was a problem, so perhaps even if remuneration commitees knew CEOs and would-be CEOs did not, and so did not demand so much more.

    And perhaps ignorance, if not bliss, would avoid the minor irritation of annual publication of ludicrous salaries. The outrage at these salaries is interesting. CEOs aren’t rich by the standards of the BRW top few hundred. In so far as desert comes into it, they deserve their money more than people who inherited it. Yet they seem to be the object of much more resentment than people who are richer and less deserving. I think it is something to do with the ideas in reference group theory. CEOs are in the same group as most people, that of employees, and ought – people think – be compensated according to the norms of the group, which are to do with effort and returns to skill. They deserve some more, but not nearly as much as they get. Hence their salaries are resented.

  4. Andrew Leigh says:

    It’s true. I can think of many more good arguments for an inheritance tax than for a cap on CEO compensation. But in recent years, the ALP has strongly preferred the latter to the former.

  5. Evan Thornley says:

    We can debate whether outstanding performance by a CEO merits exceptional compensation as a philosophical issue, but what is the justification for poor or mediocre performance getting exceptional compensation ?

    Most Boards and CEO packages use lousy performance metrics not tied to the long-term capacity to outperform competitors. When Board compensation committees review benchmarks of management compensation from “similar companies”, they then fail the simple test of ensuring that compensation is accurately matched to company performance against the same companies.

    It’s not that hard. Let’s say even if you believed that top performance justified say a 20% annual increase in pay when ordinary workers contributing to that same performance are getting 4%, then surely “top performance” by any useful definition would mean sustained (at least 3 years, some would argue 5 years or longer) abnormal returns to shareholders versus competitive companies. That is, LONG-TERM share price and dividend performance superior to similar companies, so you get no brownie points, for example, if you’re a mining company CEO sitting on top of a commodity price boom unless you outperform other mining co’s sitting on a similar boom.

    Then, if the truly top-performing (say top quartile) CEO’s got say a 20% increase per annum, at least you could see it tied to performance. Perhaps 2nd quartile CEOs could expect an annual increase of say 6% – a little above the average worker but not better, for example, than their own top tier of internal performers.

    Third quartile performers should firstly be put on notice that performance improvement is required and certainly not get any pay rise at all and indeed some reduction given that a large part of their pay is meant to be “performance driven” and they’ve landed in the bottom half.

    Fourth quartile performers should have substantial reductions in compensation if they are still there at all.

    Now if this sort of outcome occurred across all CEOs, we would be somewhere between what average workers and average shareholders see in annual returns. That would make some sense.

    The fact that CEO compensation outpaces all other metrics suggests that “pay for performance” is a myth. Which brings us back to the philosophical arguments – do you believe CEO pay should rise faster than rewards to either shareholders or workers regardless of competitive performance ? Apparently much of the commentariat on this issue believes the answer is yes. Bizarre.

  6. Fred Argy says:

    I agree with most of the observations. I don’t believe it is practical or sensible to regulate executive salaries (whether by putting caps or any other means). In any case the cost effects of high executive salaries are too small to worry about. It is really about perceptions of what is ‘fair’ and socially acceptable in a situation where low-paid workers are being screwed.

    I believe three things are clearly needed: these guys should be constantly reminded of their moral obligations to the community as a whole(hence my letter); they should be subject to genuine performance tests (relative to like companies and over a sustained period, as Evan Thornley suggests); and some way should be found to tax some of that rent away from them (and Andrew’s inheritance tax makes good sense but seems politically way out for the present). Any more politically viable ideas?

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