Date: 05/08/2014 Duration: 00:22:22

CEO pay continues to climb, despite increased regulation and a popular backlash against the huge remuneration packages paid to senior executives. The gap between highest pay and average pay is ever-widening, and the High Pay Commission has warned of the negative organisational and social side-effects that this can have. With CEO pay a topic of intense debate, the CIPD has recently published a literature review on executive reward, written by academics from the London School of Economics.

As the literature review explains, much of the research fails to find a strong link between company performance and executive pay. If this is the case, what are we actually paying for when we pay such high salaries to our CEOs, and what impact does this have? Do current CEO reward packages encourage short-termism, and are we successfully designing remuneration packages so that CEO and stakeholder priorities are aligned?

We pose these questions to one of the literature review’s authors, Professor of Management Practice at LSE Sandy Pepper. We also ask Deborah Hargreaves, Director of the High Pay Centre, and we speak to reward professional Mark Childs, who is the Managing Director of Total Reward Group.

You're reading the transcript to the CIPD podcast series.

Philippa Lamb: CEO pay is always a hot topic with the press, public and politicians alike. Despite the economic downturn, the value of top level packages continues to climb and the gap between the pay of the average worker and that of the CEO seems to be ever-widening. Now, in collaboration with London School of Economics, the CIPD has produced a new literature review on executive pay, the first of its kind since 2007.

Since then of course the economic climate has changed dramatically. This is also the first review since the final report of the High Pay Commission four years ago which argued that excessive pay for top executives was deeply damaging to the country and needed to be addressed. So what’s happened since then?

Mark Childs is a highly experienced reward management professional having held five FTSE 100 or Fortune 500 head of reward roles throughout his career. He currently works as a reward management consultant. When I spoke to him recently I asked him how the way that executive pay is decided has changed since he first worked in the field.

Mark Childs: Well it’s evolved very significantly and probably more than anything through the impact of regulation, through corporate governance codes. If you go back to 1994, 1995, when the whole ‘fat cat’ scandal first emerged on the public scene then the Greenbury Code on Corporate Governance really was a watershed that from ’95 onwards executive remuneration stepped into a regulated framework and that regulation has become more intense over the past 20 years.

PL: Dr Sandy Pepper is Professor of Management Practice at the LSE and one of the authors of the Literature Review. I asked him for his thoughts on why executive pay is still on that steep upward curve.

Dr Sandy Pepper: I have a theory that we can explain the rise in executive pay by using a relatively simple piece of game theory. So I want you to imagine this: imagine that the top 10% of CEOs are really able to have a significant influence on their companies, they will really create additional value for their companies that wouldn’t happen if those CEOs weren’t appointed. Imagine conversely that there's another group, let’s say 20%, who actually potentially will do damage to a company and will destroy value. And that the remain 70% are competent CEOs who will do a good job. So if you’re a remuneration committee of a company and you’re thinking about recruiting a new CEO, what you probably would be happy with is a competent CEO who is going to do a good job, who you’re going to pay fairly the market rate. But you'll sit there thinking, ‘Well actually wouldn’t it be nice if we got one of the really top performers who’s going to make a real difference to our company and create additional value?’ And you'll also think, and actually nobody is going to thank us, our shareholders in particular, are not going to thank us if we recruit one of the bottom 20% who are duffers, who are actually going to destroy vale. So you’d be happy to pay the market rate for a competent person, you’re prepared to pay above the market rate for the possibility that you might get a star, and you really don’t want to be in a position where you get one of the duffers.

This is a prisoner’s dilemma in game theory terms and what game theory tells us is that in these circumstances people will defect, they will pay over the odds in the hope that they will get one of the top performers, but of course because everybody does it they don’t get necessarily a top performer, if they do it’s by chance, but everybody pays over the odds and executive pay is inflated. There's all sorts of other explanations but I wonder if it is at heart something as relatively simple as that, that remuneration committees don’t want to make a mistake, they don’t want to recruit someone who’s not going to do a good job, they just might recruit someone who will really add value and better to be in the position of paying over the odds for competence, rather than paying the average and risking being behind the market.

PL: Dr Pepper’s theory lays the responsibility for the marked growth in CEO reward with remuneration committees. I asked Mark Childs what role the CEOs themselves have had to play in it?

MC: Well, non-executives are no different to anyone else really in a decision-making capacity, most individuals would prefer to say yes rather than no and therefore when a chief executive raises an issue of pay, just in the same way that any employee raises an issue of pay with their HR manager or line manager there is an inexorable conclusion that you’re going to do something to respond positively, you may not give the individual all that they want but if a chief executive raises a complaint then those non-executives are going to look at it and the likelihood is that there will be something favourable emerging out of it.

PL: Some movement probably upwards?

MC: Yes.

PL: I asked Mark Childs to explain what he felt were the drivers for CEOs in this position. Is the big issue what a CEO personally earns or is it more about how the package compares to his or her peers?

MC: I think it’s more about understanding the mindset of the sorts of people that end up in CEO positions, they tend to be individuals who are driven, who are results-orientated, and frankly who thrive off recognition.

PL: So it is about competition and where they are in the pool?

MC: Yes, but pay is really just an expression, it’s a badge rather than a motivator or an incentive in its own rights, just in the same way that perhaps a sales manager may demonstrate their prowess as a sales manager by having a shiny new red sports car, so too a chief executive may want to garner some recognition from the level of salary or bonus or earnings that they're able to earn. And in that sense disclosure can be a welcome thing because certainly amongst their peer group it’s an exercise in disclosing your relative worth.

PL: Agency theory is often used to discuss the interests of a company’s shareholders compared to its directors. Their interests may be different and need to be aligned and incentive pay has long been seen as a neat way of doing that. The trouble is the link between how well a company performs and how much the chief exec is paid is inconclusive: just because you pay your CEO more doesn’t mean your company will automatically do better, and it might even do worse. But if that's the case what do fat CEO reward packages actually achieve? I put that question to Mark Childs:

‘So this brings us to the slightly tricky question - what are we rewarding CEOs for? Is it about rewarding them for creating a bigger and more profitable organisation or is it that we should be rewarding them for creating a more sustainable and productive organisation? That's not necessarily the same thing is it?’

MC: No it’s not. I think the fault line is really a separation between ownership and management that there is something healthy about working in a smaller organisation where you really are the owner, or you have a real ownership interest rather than being merely a professional manager. And that does bring a different mindset. I've experienced that myself even moving from a large corporate environment into running an SME things are much rawer and there's no place to hide, your accountabilities are much sharper. And therefore one of the things that has been good about in the past 20 years of increasing regulation is it has bounced chief executives and other executives into greater degrees of share ownership and there is pressure on executives to take an increasing stake in their organisations and over a longer term as well. Those things are virtuous. In smaller companies where somebody’s the owner or they may have a significant shareholding or they’re a founder that's much more naturally instinctive. But anything which cultivates that longer term mindset and reinforces it must be healthy.

PL: As remuneration committees become bigger, executive reward has become a complex business and according to the review not all CEOs actually understand their own packages, or indeed precisely what they’re expected to do to earn them. Mark Childs again.

MC: I'm fully confident that a lot of executives don’t actually understand how their incentive arrangements work.

PL: So how can they be a motivator?

MC: Well, it’s not just about the motivation it’s also that the absence of these things can be a demotivator. But I'm not so much of the school that things have become more complex, I actually hold to the view that within listed companies regulation is driving a very high level of replication, and more and more organisations’ incentive arrangements are looking cookie cutter; they’re looking increasingly like everyone else’s, because in an environment where you’re under a high level of public scrutiny and you’re in a regulated framework people will find security in doing the same things as other people. And therefore regulation tends to limit innovation. And I think there was much more innovation and a much wider spread of executive remuneration practice before regulation really started to bite.

PL: Deborah Hargreaves is Director of the High Pay Centre and Chair of the Independent High Pay Commission. I asked her about remuneration committees and why they might have a vested interest in driving executive salaries upwards.

‘Remuneration committees are very crowded spaces now aren’t they? More and more people getting in on the action - consultants, accountants, all sorts, as you say there's quite a lot of vested interest there isn’t there in driving packages and salaries up?’

Deborah Hargreaves: There is. It seems that the whole remuneration consultancy business is based around high pay awards, because that feeds very much into the rest of their business. It’s all about competing with rivals and no one wants to say, “Actually our chief exec is good enough but he's not excellent, he doesn’t deserve a huge pay rise.” Everyone wants to say, “Well of course he's good!” otherwise it’s almost like saying, “We don’t want him anymore.” So that’s sort of built into the system. Remuneration committees are drawn very heavily from ex-executives, ex-bankers, people from the finance industry, people with a very, very comfortable background. They feel comfortable with high pay awards, they’ve often benefited from them themselves and they don’t really see that much of a need to challenge them. So that's why we’ve said it needs to be made up of different members, people with different backgrounds and people with different points of view.

PL: Should we be enforcing the publication of pay differentials?

DH: Well, we say we should. I mean it took a long time in the US to get that into the rules, that came out of the financial crisis in the US and there was the Dodd-Frank Act which reformed some of the corporate governance rules in the US, insisted on the publication of a pay ratio. It’s taken five or six years for the regulator in the US to draw up the rules for how US companies have to calculate that pay ratio and even now it’s still controversial, even now companies are arguing against it. We have argued for the same thing here. Companies are very shy about publishing that, they feel that there's not much to be gained from revealing that the top boss earns 150 times the bottom - or even the middle actually; top to average at the moment in the FTSE 100 is 133 times, and it’s hard to calculate top to bottom.

So we’ve said that figure needs to be out there as part of the public debate. There are some high profile companies like John Lewis always held up as a sort of good governance follower, they have in their constitution a 75:1 ratio so that the top paid executive can never be paid more than 75 times the average. And TSB that floated off from Lloyds earlier in June has said it wants to follow an ethical pay policy and has adopted that ratio and says the same will apply there. So that's almost being held up as a sort of best practice. We can't say what other people are doing because we don’t know and I think that would be good if we had at least that figure available and some shareholders themselves are saying that they would like to see that figure made available too.

PL: Following on from the point that Deborah made about publishing pay differentials I asked Mark Childs if he felt this was the way forward and that the UK ought to be making this data public as it is in the US?

MC: I expect it will happen more and more in a lot of countries or people will do it voluntarily. Again it can be very misleading, if you are the chief executive of a low pay sector, perhaps retail or contract catering or cleaning, your salary as a multiple of the lowest paid is going to be very high whereas if you’re in a professional services firm then it may be much lower.

PL: Perhaps useful in your own sector though because then at least you compare organisations within their sector?

MC: Yeah possibly so but it’s a crude measure, I mean if it helps individuals exercise greater personal self-restraint I would hold to the view that that's a good thing...

PL: You don’t sound very convinced.

MC: ...but not everyone would take that view.

PL: In the wake of the banking crisis and the financial downturn there's a lot of heat around incentives and bonuses. I asked Sandy Pepper what he felt their role should be in the executive remuneration process.

SP: I believe in incentives and bonuses I think the definitely do have a place in remuneration packages. I think we have one of these problems that I would characterise like this: one aspirin is good for you, 100 aspirins will do you harm. So to say that bonuses have been problematic therefore we should ban them completely is a specious argument. What I think has gone wrong is that there's been a sense that bonuses and incentives are good, so more of them must be better.

But I don't think the relationship necessarily works like that. I think that sort of implication of a linear function, a linear relationship between pay and performance is not right, but I do believe that incentives, weak incentives I would call them, can signal the right kind of behaviours, can indicate what companies want of their executives at all levels. I am not saying that bonuses, incentives are a bad idea what I'm saying is that the way that they have been used in practice may have had all sorts of unforeseen consequences.

PL: Deborah Hargreaves, Director of the High Pay Centre, suggested that a positive approach to the management of exec reward might be to follow the lead of other European countries such as Germany and invite, or co-opt, people from lower down in the organisation on to remuneration committees, or even boards.

DH: I think we could have elected representatives on boards and on remuneration committees, if you had two or three onto a board they wouldn’t feel isolated, they wouldn’t feel alone and with a little bit of back up and training I think they could make a valuable contribution and there is a precedent for it, it does happen overseas. In Germany there's a two tier board structure where the supervisory board, and this is the board that sets pay for the executives, is made up half of shareholders and half of workers, but other boards, unitary boards in Sweden, Norway, the Netherlands, they have ordinary representatives on it.

There is a precedent for having them on the UK type board and I just think that this would open up a dialogue with the workforce that doesn’t always exist in the UK. And again boardroom diversity is an interesting issue on many points. We’ve talked a lot about women in the boardroom but I think there could be a whole shake-up in board members to bring them from more diverse backgrounds, you know, customers as well, people from different sorts of areas, different backgrounds, board positions should be advertised more openly. At the moment they’re very much just held within head hunters. I mean we’re getting off the issue of pay here and talking more broadly but I do think board structure is an important issue as well.

PL: Yes, we might get different outcomes on pay if we had a more diverse and a more transparent structure.

DH: Yes, and a board more prepared to challenge.

PL: There's clearly more we could usefully know about executive remuneration and I asked Sandy Pepper what further research he thinks should now be done?

SP: So I think there are two areas that researchers should be focusing on. The first is - and this is beginning to happen - is a much better understanding of executive behaviours. So not the sort of simplistic view that more money means more motivation but really getting to a better understanding of the relationship between pay and motivation, pay and performance, a behavioural perspective on these questions rather than the sort of more analytical economic and financial perspectives that has dominated research over the past 35 years. That's one area.

The other area is how institutional change can be brought about. So this is a system and government and regulators play a part in it and government and regulators have been, in various ad hoc kind of ways, trying to influence executive pay. But the way that they’ve done it has sometimes had completely the opposite consequences of what was intended. Pay transparency, more and more information about senior executive pay has not suppressed the growth in pay as was originally thought, if anything it’s fuelled it.

So I think there is a need for research on public policy perception. How can the institutions that are involved in executive pay, the formal and the informal institutions that influence how people are paid, how can they bring about change so that I think what everybody regards as a desirable end of more moderate pay and a better connection with performance can be brought about?

PL: So in this complex and increasingly regulated space what role should the HR director play? Mark Childs.

MC: So it’s been an evolving picture. In the past HR directors actually had more influence because in listed companies the remuneration committee was a less crowded space. Now there are a lot more people in on the act and for a start most listed companies now have a compensation benefits director. Through the 90s I was comp and ben director of three companies. I was the first ever incumbent in those roles, they didn’t exist in the past.

So you've got specialists within HR coming in to compete for the space. You have company secretaries, or legal and compliance people trying to come in on the remuneration committees because of their concerns about compliance with the governance code or the regulators’ code. You have non-executives taking a heightened interest; you've got chief executives and corporate PR people having a heightened interest because of the reputational damage that might come out of inappropriate pay decisions and you have remuneration consultants who have very often crowded out the influence and the space that the HR director previously occupied. You’re thinking more narrowly perhaps about reward practitioners. The other great disappointment I have is that I find more and more reward practitioners are becoming overly focused on executive remuneration and spending a high proportion of their time, perhaps dealing with just ten or 20 people’s remuneration.

PL: Rather than organisation-wide?

MC: Indeed, indeed and therefore there's a relative neglect of incentive plans or reward programmes amongst management and general employee population because of this over-focus on executives. An enormous amount of resource and HR spend is focused on a very small number of people who undoubtedly have a profound influence but I think it makes the job of a reward director or a comp and ben director in an organisation rather duller because they're working in a more regulated space, they haven’t got so much room to innovate and they are much more in a world where they’re checking boxes; they may be rubbing shoulders with some very senior and high profile individuals but for me the satisfaction, the quality of that work is diminished by the regulationary framework.

PL: That's it for this month. If you’re interested to read the literature review in full you can download it from the CIPD site. And if you’d like to share your own thoughts it’s #cipdpodcasts.

Thanks for listening.