Shake up executive pay for a real bonusAnthony Hilton
The London Evening Standard, 3rd July 2014
When Professor John Kay presented his review of the functioning of the equity markets, one of his key recommendations to combat short-termism and make markets work better for listed companies and for investors was the creation of a shareholder body that would be able to put pressure on underperforming managements.
Three years on, the Investor Forum has been established, and yesterday it named Simon Fraser as its first chairman and Andy Griffiths as first chief executive. The hope is that under their leadership, the forum should be operational from the autumn.
Getting here has not been easy but, as the press release made plain with 11 endorsements ranging from Otto Thoresen of the ABI to Barclays chairman Sir David Walker, there is now widespread — although by no means universal — recognition that it is needed.
There seems to be much more widespread acceptance that for the system to work well, shareholders need to take an active interest in the companies in which they invest and be prepared to speak to management, and indeed seek to change management when they do not like the way things are going.
The philosophical justification for these tactics is a desire to create a longer-term focus in the markets in the belief that this will provide a better climate for companies to invest and grow, and increased returns for investors.
But even if it is on the side of the angels, the Investor Forum faces a daunting challenge.
This is in part because there is overwhelming evidence since the arrival last year of a stewardship code that a significant number of fund managers will still much rather sell underperforming shares than spend time and money on engaging with management.
The forum will have in its ranks some of the huge international investors who operate in the London markets.
To retain some form of consensus and not scare the horses, the chances are it will focus only on really big issues, and will probably seek to act out of the public view.
Welcome though its interventions should prove to be in the promotion of long-term thinking, we should not underestimate the strength of the forces lined up on the other side, creating the emphasis on the short term.
Indeed, as if to underline this fact, this week has also seen the publication of economic statistics that highlight yet again how little companies are investing given profits are at record highs, balance sheets are awash with cash and the economy is in an upswing.
Almost by definition, corporate investment requires a willingness on the part of management to think long-term because it involves big risks and can take years to pay back. Conversely, a lack of investment implies a focus on the short term.
The economist Andrew Smithers is convinced this is a huge problem for Britain. Productivity growth — the increase in output for every hour worked — is feeble, and has been since the financial crisis erupted.
Smithers says this is because managements are obsessed with preserving their short-term bonuses, and will not do anything to put these in jeopardy.
Thus they prefer to increase output in a risk-free way by hiring more cheap workers to use old inefficient kit. The alternative long-term solution would be to take the plunge and buy state-of-the-art stuff.
But they don’t do that because it costs money — and that might dent their short-term profits and torpedo their bonuses.
When the entire system of executive pay drives short-term thinking — which Smithers persuasively argues it does — it is hard to see what a few agitated shareholders can do to turn the tide the other way. They will no doubt have isolated success, but it will be just that.
Indeed, if you accept this thesis, it follows that the whole idea of engaging with underperforming companies is a mistaken attack on the symptoms of corporate decline, and this prevents there being a proper focus on the root cause of decline, which is to be found in the way top executives are paid.
In Smithers’ words: “Modern incentives have increased the difference between the short-term interests of management and the long-term interests of shareholders… Modern incentives are thus contrary to the interests of long-term shareholders.”
People generally are reluctant to accept the fact that paying performance bonuses makes things worse not better — the executives themselves are certainly in denial — but there is a wealth of research to show this is the case.
A recent paper by Michael Cooper, Huseyin Gulen and Raghavendra Rau says bluntly: “We find evidence that chief executive pay is negatively related to future stock trends.”
The idea that high pay is needed to attract the most talented executives is also at odds with reality.
Perhaps the most widely understood business theory is the Peter Principle, which holds that people are promoted until they get to a level where they are incompetent. This also applies in the boardroom.
It gets worse. In The Peter Principle Revisited, a team of researchers analysed alternative ways of deciding how to promote people.
Psy-Fi Blog reports that they discovered, statistically speaking, the best approaches were either to promote someone at random, or even randomly promote the best or worst team members.
None of this, of course, makes a case against having an Investor Forum, and should not be taken as such. What is important though is that we do not believe it will solve all our problems.
That will only come when we collectively realise that the present executive remuneration regime is slowly destroying our economy, and we then resolve to do something to change it.
© 2017 Andrew Smithers