21 September 2011
Today many of our largest public companies have become so complacent, unaccountable and bureaucratic that they resemble bad governments. Outwardly they tick all the governance boxes, but the reality is that their managements barely answer to anyone. Those supposed to check on abuse and poor performance — auditors, corporate pension fund trustees — lack real independence. The result is that companies are too focused on the short term and spend too much money on rewarding their executives.
Vince Cable has revealed in a recently published paper the extent of the problem with executive pay. It shows that the total remuneration of the average FTSE 100 company chief executive has risen by more than 400 per cent over the past 12 years, to £4.2 million. Take-home pay has more than doubled to £2.5 million since 1999, moving from 47 to 88 times that of a full-time UK employee. The take-home pay of a mid-size FTSE 250 CEO has doubled to £1 million, moving from 24 to 36 times median pay.
But there is no correlation between pay and stock market performance. The pay of FTSE 100 chief executives rose 13.6 per cent every year from 1999 to 2010, but the FTSE itself rose by an annual average of just 1.7 per cent. Not only that: pay continued to rise despite big falls in share prices in 2000-02 and 2007-08. Not much accountability there.
No reputable study has found a significant correlation between senior executive pay and long-term corporate performance. But one correlation is well known: the bigger the company, the bigger the pay package. This link encourages takeovers and mergers, rather than organic growth. Takeovers always benefit senior managers, win or lose: the acquiring CEO’s pay goes up, while the bosses of the bought companies are protected by golden parachutes, even though 60 per cent of takeovers destroy economic value.
The situation is particularly bad in the City, where bonus deals pushed the banks to take excessive risks. Even now bonuses draw able people away from joining entrepreneurial businesses, where the short-term rewards are less. It is often argued that finance is creative and requires high bonuses to attract talent. But the evidence shows that bonuses stifle creativity by tying cash too closely to outcomes rather than following imaginative leads. The more creative the activity, the less those involved should be rewarded with bonuses.
What is the justification for these pay awards? There isn’t one. But that doesn’t mean there is nothing we can do to restrain them, or to align pay more closely with long-term growth.
The key is to promote better ownership by shareholders. As McKinsey and Deutsche Bank studies have shown, companies that do this perform better over the long term.
So here are two suggestions. First, we need vigorous enforcement of the trust law of ownership. A share’s vote is part of its value, and legal action should be taken against the directors of companies and financial institutions who fail to use their votes in the long-term interest of their beneficiaries. In theory, pension funds ought to be superb shareholders, given their fifty-year focus and near-permanent holdings in large companies. In fact, despite honourable exceptions such as CalPERS in the US and Hermes in the UK, they have been a disappointment.
The second is to make it easier for shareholders to elect particular non-executive directors. As matters presently stand, however angry you are at a particular company or pay award, there is next to nothing you can do about it; as a shareholder you get one vote per share for each of the directors at board elections.
This could be changed by introducing cumulative voting. This allows you to put all your shares behind one candidate. The effect of this is to give a greater voice to small shareholders. It would help to break up cosy boardrooms, and bring in more challenging, independent voices.
Corporate governance is not an alluring subject. But making more companies work harder through better ownership would have a gigantic effect on Britain’s competitiveness and prosperity. It would lift profitability and employment, while restraining executive pay. And even a small improvement in shareholder returns would hugely strengthen our pension system over the long term.