5 April 2017

Does executive pay really need fixing?


CEO pay packages are just dreadful, MPs tell us today, and must, therefore, be changed. Given that MPs are more intelligent, better educated, have more information, and are generally just more perfectly formed than the rest of us, we must do as they say, of course. We know that MPs are all of these things because they tell us they are.

The Business Select Committee has decided to complain about executive pay. One of the drivers of the rise in pay levels is, they say, “executive greed/contagion: no CEO will be advised to accept lower pay than the industry benchmark and high pay in one company or sector can ‘spill over’ into others, contributing to the ratchet effect”.

CEOs tend to want the market rate. Their employers, the shareholders, tend to pay the market rate. This appears to become a problem when someone starts earning more than an MP, which isn’t the strongest argument a politician has ever put forward.

The report does, of course, get worse than that. Their major complaint is about something called long-term incentive plans, or LTIPs. These tend to be complicated, often involving some mixture of base pay, cash bonus payments, stock awards which mature over time and so on. For those who get things right as a CEO, they also tend to mean lots of moolah.

We’re told that these are a bad idea for several reasons – the amount of moolah being only one of them. There is the complaint that they can include comparisons to other companies in the industry. They’re complex too. They should be replaced with simple stock option packages. Yes, CEOs should share in the success they create but we should be paying only for what success they do create.

At which point we can simply marvel at the effrontery of all of us being told how we may pay our own employees, for that’s what those CEOs are, even if indirectly through our pensions and so on. But we can – and should – go further. These MPs are some 30 years behind the times.

Simple share option packages were how CEOs used to be paid and we found out that didn’t work very well, which is why we generally moved to LPITs.

For example, the committee tells us that an LPIT could lead to the CEO striving for a short-term boost to the stock price as shares are vested. Yes, it could. But that problem is vastly worse with a share option just coming up to vesting, which is why we made the change.

Similarly, we are told that an LPIT can make managers think short-term instead of long-term, which is really what we want. This ignores the fact that share prices are the net discounted value of all future income from it. Today’s price, therefore, by definition reflects the long-term. Someone blowing up the company’s long-term prospects for short-term gains reduces the share price, not increases it. Otherwise Amazon, which because it continually reinvests, rarely makes a profit, would not be worth more than most small countries.

There is also that complaint about industry comparisons. This is not, as the MPs seem to think, a case of CEO of widget maker A gets x, therefore CEO of widget maker B will then demand x. Both models offer stock, either as options or as shares themselves. If the widget manufacturing industry just generally becomes more profitable – the sort of thing which can obviously happen in mining or extraction companies as the global price rises – then we don’t want to be paying the CEO more for things entirely out of his control. We want to pay only on the value added.

Therefore, it makes sense to compare performance with other companies in the same industry so as to subtract the general industry effect and leave only the particular CEO effect. Our stock awards can now reflect that value add, not just the rise in share prices across the industry.

But even more frustrating than this theoretical misunderstanding is that the LPIT method has proved so popular because it has encouraged more long-term thinking, not less.

The committee has managed to grasp the wrong end of the pay package stick here. Their recommendations would set us back several decades to a pay model that we abandoned precisely because the new one was better at the MPs’ stated goals. Perhaps it is MPs’ pay that needs changing. If we offered the market rate, we might get some who knew what they were talking about.

Tim Worstall is senior fellow at the Adam Smith Institute