Labour Party policy input on executive remuneration
In November 2018, John McDonnell, Shadow Chancellor, published a review he had commissioned from a group of 13 academics into the thorny subject of executive pay. The review is described as “independent” but the intellectual allegiance of the contributors is evident in the title: “Controlling Executive Remuneration: Securing Fairer Distribution of Income” (my italics). The unfairness of current pay differentials and the belief that it will only ever be addressed by legally enforceable controls is the starting premise of the paper.
A number of the writers are active in the Labour party, including the editor, Professor Prem Sikk (University of Sheffield); one contributor, Professor Alastair Hudson (University of Strathclyde) ran for Parliament on a Labour ticket in 1997; Anne Pettifor, Director of Prime economics policy research, is on the Labour Party Economic Advisory Committee and is declaredly anti deficit reduction and pro-state. Several of the academics, for example Jeroen Veldman and Martin Parker, believe that current capitalism is profoundly biased in its allocation of resources and privileges to managerial and shareholder “elites”.
I point out these strong inclinations not to present an opposing political viewpoint, but to highlight the danger in believing this is in any way an “independent” review, which the Shadow Chancellor claims. He says in his introduction that “the contents of this document form a submission to Labour’s policy making process; they do not constitute Labour Party policy nor should the inclusion of conclusions and recommendations be taken to signify Labour Party endorsement for them.” That is questionable. There are some very radical proposals in this report, including employee votes on individual directors’ pay and a stakeholder-set total pay cap. If Labour were to win a general election, we could expect similar measures to form part of an assault on the current status quo in UK corporate governance.
I would add that the document lacks the intellectual rigour we might expect given the academic credentials of the various writers, four of whom (including Prem Sikk) are professors of Russell Group universities. Following academic protocol, the research quotes its sources at every point in its argument, but it merely quotes the conclusions that support its own arguments. There is no attempt to appraise the quality of each source. Notable cases are the citing of the 2014 IDS report for the High Pay Centre, stating that there is either no relationship or at best a weak link between directors’ pay and performance; and repetition of the research conclusion in The Spirit Level, written by meta researchers Richard Wilkinson and Kate Pickett that health and social problems are worse in countries with high wealth disparity. The IDS methodology produced statistical nonsense (as I have previously demonstrated) and any top grade business professor should have spotted it. The Spirit Level is still the subject of debate after a thorough debunking by Christopher Snowdon (The Spirit Level Delusion).
Following an executive summary of recommendations and an introduction, Chapter 2 of the review presents the context of executive remuneration – it describes current practices for executives and other employees. It shows how the differential of FTSE 100 executive to average pay increased from 20 times in the 1980s to 160 times in 2017. Subject to a missing definition of total remuneration and distinction between remuneration awarded and remuneration realised, we do not dispute their findings and anyone must find them disturbing. What we do dispute are the accompanying statements that the link with company performance is virtually non-existent (this is not true) – it contrasts executive pay increases with low growth in the FTSE 100 index, ignoring dividends entirely, a key element of shareholder returns. It makes the extraordinary sweeping accusation that “the financial sector has been a serial offender, and actively engaged in mis-selling financial products, rigging foreign exchange rates, interest rates, money laundering, tax avoidance and tax evasion to boost profits, shareholder returns and performance related executive pay.”
It states: “There are no statutory mechanisms for clawing back bonuses though a number of companies claim to have mechanisms for clawing back some of the bonuses at the board’s discretion.” In fact clawback in banks in large financial institutions is mandated under the EU Capital Requirements Directive (CRD IV).
The report claims that executive pay continues to soar – yet even the High Pay Centre has recognised that it has flattened out in recent years. It takes a few egregious cases of abuse (eg Carillion and Persimmon) and draws the conclusion that controlling action is required for the 7,000 UK companies with more than 250 employees.
Chapter 3 looks at the consequences of inequitable income distribution, including its implications for access to housing, education, food, pension, healthcare, transport, justice, security, democratic institutions “and much more” and builds a case for stronger control of executive pay.
Chapter 4 seeks to document the failure of Government, shareholders and institutions to exercise such control. Here the political slant is evident. The section starts with an attack on the failure of corporate governance codes from the time of the original Combined Code in the early 90s: “The corporate governance codes assume that corporations exist primarily for the benefit of shareholders and that the levels of remuneration are a matter for elites. Professor Sikka is particularly fond of the word “elites” (he clearly does not number university professors in their ranks). The paper rolls out the old canard that directors sit on each other’s remuneration committee and have no interest in controlling executive pay, in democratising decisions or choosing lower benchmarks. We believe this is serious libel of non-executive directors who, in our experience, are fastidious in dealing objectively with executive pay. The paper goes on to attack the concept of maximising shareholder returns and builds a case for attending to the interests of all stakeholders.
The attack on the UK corporate governance record is particularly weak and full of errors. For example, “the corporate governance codes have secured some disclosures of executive pay but the information is poor. Executive remuneration disclosures in annual accounts often understate the pay collected by directors. Many receive perks such as subsidised housing, chauffeur driven cars, the use of private jets, private healthcare help with house buying and school fees, and these are often poorly accounted for. The use of share options complicates calculation of the value of [the] executive package and often understates it. Company executives have also been known to fiddle share options by backdating them (sic) to maximise their own personal gain.” Spot the hidden truth amongst the lies (answer – executives do get private healthcare!) The writer of this section does not seem to realise that directors’ pay disclosure is not a matter of corporate governance codes but is mandated by regulations under the Companies Act. The value of all remuneration has to be disclosed, the valuation methodology is prescribed and the reports are subject to audit. The writer of this section presents no evidence to support these gross statements.
The section goes on to attack the “notion” of maximising shareholder returns and the use of shares and share options to align the interest of directors with shareholders at the same time allowing them to push up share prices through share buybacks, excessive dividends and by issuing optimistic earnings forecasts. Next the section demonstrates how the interests of shareholders have become increasingly short term and claims shareholders have become increasing unfit to exercise any joint control on executive pay.
Finally, the chapter attacks the failure of the Conservative Government to check executive pay. It acknowledges the introduction of the new June 2018 disclosure regulation requiring listed companies to report and explain the pay ratio of CEO to employee pay quartiles and the encouragement given to the Investment Association in publishing the name and shame list of shareholder resolutions obtaining less than 80% of shareholder votes. But it complains that the name and shame register has not led to a more equitable distribution of income. In fact, the register was published for the first time in December 2017, so it is hard to see how the impact might be felt by now. The report said the only sanction the shareholders have is to sell their shares – but of course they can also vote directors off the board. It also complains that the new UK Corporate Governance Code, introduced by the FRC in July 2018, has failed to curb excessive executive pay.
Chapter 5 presents the researchers’ recommended reforms. Having concluded that the pay gap is growing and damaging to society and that current corporate governance regulations and codes have failed to control executive pay, they have recommended a number of radical new control measures. “The challenge is not only to devise mechanisms that constrain undeserved executive pay in large companies but also create mechanisms to enable workers to secure an equitable share of income/wealth created with their own brain, brawn, sweat, commitment and energy. The key to that is to empower employees of large companies to vote [on] executive pay.”
The precise recommendation is rather confused. Employees would have the power to vote on individual “executives’”pay. It is not clear whether this means parent company executive directors or a wider population of executives and managers. Certainly they are proposing reporting the names and total remuneration in bands of people earning more than £150,000. In a major multinational this could include well in excess of 1,000 employees and it seems unnecessarily intrusive. It implies there is something reprehensible about earning that much rather than recognising the important contribution these people make.
How the vote would work is vague – if the vote goes against the package, what happens then? Incentive payments require a vote on each element with at least a 50% voting turnout and a 90% vote in favour but, again, it is not clear what happens if the vote is less than 90%. There is then a complicated system of yellow cards for the directors if any remuneration vote is less than 80%. This is accompanied by the threat of being voted off the Board.
Employees and customers will also have the power to impose a cap on individual total remuneration. The practicalities of this are not discussed. Who proposes the cap that employees vote on?
For me, the big problem with employees voting for executive pay is they have no accountability for the impact of the pay package, ie the success of recruitment, retention or motivation of the executives. So what reason would they have for being anything but parsimonious? The report also recommends a limit to corporation tax deductability for total executive remuneration. This would presumably require the Government to specify a limit.
The report recommends a downgrading of the remuneration committee responsibilities to advising the Board (if the board chooses to have a rem com at all). But the IA Working Group and the FRC in the new UK code have both emphasised the importance of having a rem com which is expert in remuneration matters and particularly a rem com chair who is expert. They hope this will avoid the sort of error that was seen with the Persimmon share plan. Passing the responsibility to the whole board will be a backward step.
The review says that if there is a rem com it must have representative of employees and other stakeholders. Do the writers really mean a customer representative? How is such a person selected? I suspected the “other stakeholder” piece is a way of justifying the increased influence of employees.
The cult of bonuses is to be discouraged. Bonuses, if any, should only be paid for carefully specified and extraordinary performance. The word “cult” is heavily value laden and the recommendation shows a failure to understand the principal reason for bonuses, which is to ensure pay is justified. The writers seem to subscribe to a belief that most high pay in large companies is not justified; yet they are seeking to destroy the very mechanism that ensures it is.
The same applies to share incentives. They recommend proscribing them and allowing cash only, in order to avoid abuses and complexity. Executives would have to buy their own shares.
A number of other recommendations in the review appear to be redundant given Government existing and pending new regulations:
• publishing executive remuneration contracts – all the information on executive directors is already disclosed in the annual remuneration report;
• pay differentials between executives and employees to be analysed by gender and ethnicity and published – the former requirement is already in place; proposals for ethnicity analysis are currently under consultation;
• executives should not be compensated for tax changes – most companies do not do so anyway;
• clawback should be reinforced by the Companies Act – this is generally unnecessary as it is open to companies to sue dishonest or grossly failing executives. For Banks and major financial institutions, it is already inscribed in the regulations;
A particularly radical proposal is that in the case of companies with deficits on their employee pension scheme, their directors must not be eligible to receive any bonus or increase in remuneration unless they have reached a binding deficit reduction agreement with the Pensions Regulator. Given that a pensions deficit is a theoretical figure determined by the actuaries, such a proposal could put some serious pressure on the actuaries.
Finally, they recommend a newly constituted Companies Commission to oversee and enforce all these new controls and other aspects of UK company law – in other words a good old-fashioned Quango.
The sad thing about this report is that 13 highly intelligent and well informed academics can only come up with solutions which involve legislative control. There is a widening gap between top and bottom pay, although top pay is not growing at the speed they report. More serious is the problem of upgrading low value work at the bottom end of society. Pulling down top pay is not going to help this. All the time these academics are blinded by a prejudice about executive greed and capitalism and false assumptions about variable pay and the lack of a link of pay and performance they are not going to come up with any real and lasting solutions.
What is MM&K’s diagnosis and prescription?
1. High pay is principally a matter for shareholders, and the main test should be that it is justified by performance. This makes the use of bonus plans and share plans essential.
2. Capping executive pay is a potentially damaging interference in free markets and must be resisted.
3. We think all the measures are available in terms of disclosure, shareholder voting and incentive plan design. It is now up to shareholders to exercise their stewardship to ensure companies justify their pay levels.
4. We agree with the academics, however, that pay ratios have damaged trust over time. This issue has come to a head in recent years because of the publicising efforts of the High Pay Centre, not because the gap is still widening faster.
Using a somewhat out-dated Human Resources term this is a matter of internal equity. In the late 1970s and the early 1980s, the principal aim of pay structures was to achieve internal equity – which required equal pay for work of equal value and a means of assessing the value of jobs – ie job evaluation.
Grading structures based on job evaluation controlled the salary differentials between roles. They also determined the level of access to bonuses and benefits. But they fell out of favour in the late 1980s and the 1990s because:
• grade changes had become the principal route to earning more money and employees and their managers devoted much time to getting jobs re-evaluated and upgraded.
• managerial and professional pay, in particular, became more focussed on external benchmarking as the talent markets became more active. Salaries were pegged to external benchmarks often at an individual job level rather than a structural level. This has led to criticism of benchmarking as an inherently inflationary process.
• the de-layering of organisations which was possible with modern technology meant that managers (at least in their own eyes) often added substantially more value than the individuals who reported to them, so there was no natural brake on increasing the pay differentials.
5. There may now be a case for re-introducing a framework of internal differentials using job evaluation concepts. This could be communicated to employees as part of the Section 172 disclosure and would be more informative than the statutory pay ratio reporting.
6. We see no reason to change the composition and responsibilities of the remuneration committee. Corporate governance guidelines are emphasising the importance of remuneration experience in committee members. We think putting employees on the remuneration committee will achieve very little and create expectations that cannot be met.
For queries and further information, please contact Damien Knight