The biggest way in which executives can take from society is not by paying themselves too much. It’s by coasting and failing to create value for wider society. The level of pay attracts most public anger. It is easy to understand why – the average FTSE 100 chief executive is paid £5m, 178 times more than the average UK worker. If CEOs didn’t take so much for themselves, the argument goes, their slice could be reallocated to others. This fixed-pie mentality is wrong. CEO pay should ensure that businesses serve society, not just executives. But the best way to do this is to incentivise the CEO to grow the pie for all. The median FTSE 100 company size is £7bn. If a CEO creates 1 per cent extra value, that’s £70m, which swamps any savings from reducing his or her pay. But does any of this increased value go to society? It does. Successful companies survive and grow, paying taxes, creating jobs, paying suppliers, and providing goods and services to customers – often for free. While the tech boom has created elites, it has also transformed everyone’s lives, giving us free access to search engines, mapping, online banking and shopping. Executives must be held to account for errors of commission, such as unnecessary job cuts. Much less visible, but far more destructive, are errors of omission. If executives coast, and fail to create jobs or launch products, the losses can be substantial. But the way that we vilify business encourages coasting. When taking any decision we should compare the costs with the benefits. Yet we often think about business only as a cost. The High Pay Centre has a counter that shows CEO pay growing in real time as you browse the website. There is no counter for the amount that firms pay to workers or suppliers, or the value customers derive from their products – and little public punishment of companies that coast.
How do we reform pay to encourage innovation? By focusing on the structure, not the amount. Complex, opaque bonuses encourage myopic behaviour, such as cutting investment, to meet short-term financial targets. Instead, pay should obey three principles: it should be simple, transparent, and long term. Long-horizon equity does just that; shares are easy to value and they depend on the long-term stock price. In the long run, the stock price captures value not just for shareholders but stakeholders as well. Evidence in peer-reviewed journals shows the benefits of reforming pay structures. Granting CEOs long-term equity, for example, means not only higher future profitability, but also innovation and stewardship of the environment, as well as customers, society and, in particular, employees.
In contrast, short-term equity induces CEOs to cut investment to meet earnings targets. Moreover, CEOs with high equity stakes outperform those without by 4-10 per cent a year – incentives work. Perhaps CEOs who know that their firm is going to do well will ask the board for stock (rather than cash) in the first place? The authors do further tests to show that it is causation, not just correlation – the effect is stronger where institutional ownership, governance, and product market competition are all weaker – settings in which coasting is a major concern. The above studies change only the CEO’s contract and keep everything else constant, addressing concerns that the individual at the top matters little in companies’ overall success because he or she is only one employee. Other staff matter too, and should also share in success. One way to achieve this is to give equity to all employees, not just top executives. Overall, we must
shift the focus from pie-splitting to pie-enlarging, from pay levels to pay horizons. Great firms create value for all – let’s focus our reform efforts on creating great companies.