Executive pay: we need to think beyond money

Five Minute Economist

Image © Herry Lawford

The main political parties have achieved near-consensus that something needs to be done about executive pay. There is an argument that Government has no role in this area, and that private firms, with all their incentives to seek greater profits are the ones best-placed to design pay schemes that work. Except that they are apparently not very good at doing just that. There is a growing body of research that shows that the link between pay and performance is simply not clear-cut. Studies by psychologists such as Dan Ariely have in fact shown that paying people to do things often makes a task less enjoyable and makes them spend less effort on it. 
So, we have a problem. If pay and performance aren’t so closely linked after all, then many firms simply aren’t properly incentivising the best people for the job to do the best job they can. It means that firms are likely to have higher costs, which feed into higher consumer prices, for no extra benefit. We aren’t putting resources to their best possible use because we aren’t getting the performance we are paying for.

Much of the political debate has stemmed from a feeling that pay is too high, ignoring the more fundamental issue of whether firms are properly incentivising employees and executives to perform. The different parties have therefore set out solutions on how to restrain pay. David Cameron has suggested increased transparency and giving shareholders binding, rather than advisory, votes on remuneration packages. Meanwhile, Vince Cable as well as Labour leaders have expressed some support for having employees on remuneration committees. But both of these options have flaws. Taking an informed view as to whether an executive pay package is appropriate takes effort and analysis. What are other companies doing? What is the risk of losing an employee to a competitor company? What is the right balance between a fixed salary and a performance-based element? How should performance be measured? Crucially, are there other ways of compensating employees that might work better? Those with only small shareholdings in a company don’t have a strong incentive to properly monitor pay structures, or answer these questions. Those with large shareholdings and strong vested interests already do have an incentive, and arguably already have sufficient clout to be able to place pressure on companies to change pay schemes, should they wish to do so. So it isn’t clear that changing shareholder rights is going to make a big difference.
On the other end of the spectrum, employees within a company are certainly likely to have better information about how the company operates, and better understand what drives performance in their organisation. But do they know what alternatives are available? Do they know what works well in other companies? And can they be relied on, in the interests of fairness, to vote against better pay packages which they themselves might benefit from one day?

Ultimately, we need to focus on better understanding what works. We need to understand what incentivises people to perform and what doesn’t. For employees generally, autonomy, the freedom to be creative, and ensuring people have a sense of purpose have all been shown to be important in driving motivation, as discussed in Dan Pink’s book Drive. Chuka Umunna was right to note in his recent speech that pay alone does not drive incentives. From this we need to learn that measures like increasing pay transparency, and trying to encourage better shareholder engagement in voting on pay packages is just tinkering with the edges of the problem at best. At worst, it can be counter-productive: regulatory measures in the US in the 1990s to increase transparency in executive pay arguably increased the ratchet effect, whereby benchmarking of executive salaries led companies to continually attempt to pay above average to be sure that they are getting the best talent. 
We need to fully realise that motivation isn’t just about money. We need to better understand which practices work and which don’t – for employees earning the lowest wages to the executives at the top. The public sector could take the lead in this area: undertaking research and restructuring public sector workplaces to better increase motivation without necessarily raising overall pay.

In the current climate, surely it’s worth doing even if just for the potential to reduce long-term costs. The executive pay “problem” isn’t going to be solved until we know what works.


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