Executive Compensation Briefing – Volume 12 No. 5, 1st April 2015

Economist and asset allocation advisor Andrew Smithers shows how current remuneration practices are damaging the UK economy and calls for urgent action by whoever is in No 10 on 8 May….

Dear Prime Minister,
We are faced with the prospect of growing poverty arising from declining living standards. This is inevitable unless we can increase productivity. To reverse the declining trend of recent years is the key issue for managing the UK economy and nonetheless one barely mentioned by politicians in the run-up to the general election. Politicians cannot be held blameless, but they can hardly be held to account for the general unwillingness of economists and the financial press to discuss and publicise the fundamental cause of the problem, which is the change in the way senior management are paid.

There has been a collapse in productivity on both sides of the Atlantic, in the US as well as the UK. In both countries there has been a dramatic rise in senior management salaries and even more importantly in the way these are paid. Most of these huge payments now come in the form of bonuses which depend on short-term changes in profits and share prices.

There has been a dramatic change in incentives and as the purpose of incentives is to change behaviour, we should not be surprised that the bonus culture has altered the behaviour of management. The incentives that drive chief executives today damage the economy. They have caused the collapse in productivity by discouraging investment, which in the UK has fallen from 26 per cent of GDP in 1989 to 17 per cent last year.

If we are to get productivity rising again we must change the perverse incentives that currently drive managements. The damage being done is similar to that which would be done if we allowed monopolies to rise and competition to fall. As with current incentives, this would allow companies to make higher profits without any need or encouragement to keep costs down by increasing investment and productivity. In the case of competition policy and management incentives, the interests of shareholders are not the same as those of the economy and it is not therefore sensible to look to shareholders either to prevent monopolies or to reform management incentives.

It would be quite simple to reform current practice. In place of the current perverse incentives we need ones that encourage rather than discourage investment and productivity. All that needs to be done is for bonus payments to be dependent not only on profit targets but in addition on reaching a productivity target.

For example, companies would pay bonuses only if both the profit and the productivity targets were met. A rise in the productivity of companies’ UK operations by say 1 per cent would be a condition and if this condition were not met then the bonuses would not be allowable as an expense for corporation tax. In addition such bonuses could be taxed at say 80 per cent in the hands of the recipient.

Productivity is easily measured. It is merely the corporate output per hour worked, both of which are already known to the companies and which would cost almost nothing to make public. Output is simply the sum of profits, before depreciation, interest and tax plus employee compensation.

Ronald Coase, when accepting the Nobel Prize for economics in 1991, remarked that it had the benefit of drawing attention to neglected areas of economies. I hope that this will happen as a result of the award of the latest Nobel Prize to Jean Tirole. For several years I have been commenting on the damage being done to the UK and US economies by perverse management incentives. My efforts have included several references in the blog I regularly write for the FT and in a book and articles. It was the subject of a paper I wrote for the journal World Economics in 2012 (Volume 13 No.4) called the The Change in Corporate Behaviour and was a major part of my book The Road to Recovery. More recently I have contributed to the Report by the Performance Pay Project run by the High Pay Centre and to that from The Resolution Foundation. Jean Tirole is the co-author with Roland Bénabou of a paper, shortly to be published in the Journal of Political Economy, called Bonus Culture: Competitive Pay, Screening, and Multitasking, which makes similar criticisms of about the damage being done by current management incentives.

I hope that publicity will accompany the publication of this work by the new Nobel Laureate will at last lead to the damage done by current management remuneration systems being at last widely discussed.

I hope also that this letter will contribute to a change in government policy so that we may look forward to a future in which living standards rise rather than fall.

Yours sincerely,
Andrew Smithers
Smithers and Co Ltd
This was originally published as part of selection of essays in the Executive Compensation Briefing, Vol. 12 No. 5