Performance and Reward

Why a global cap on pay makes sense now
The argument for high pay is that businesses have to compete to secure the best talent. This is a real problem but it would disappear if all top business people worldwide were paid no more than say US$500,000.
Economists usually support competitive markets because competition forces out costs and increases efficiency. However competition has manifestly failed in the market for executive talent. Costs have spiralled, but the performance of the FTSE100 has been dismal since Dec 1999. In my opinion the failure of competition in the market for executive talent is caused by distortions in the market. The executives have considerable market power and there are concerted practices coordinated through remuneration consultancies. I have raised these concerns with the Office of Fair Trading (OFT). My dialogue with the OFT can be viewed by clicking on the link “Competition Law” in the left hand column.
Actually it seems to me that a truly competitive market in executive talent could never lead to efficient outcomes in appointing people to top posts. It is more likely to ensure that we appoint the most ruthless people to top jobs. We need to develop a culture in which top people are motivated by (or at least mindful of) their responsibilities to the rest of society. Money fuelled competition between top people inevitably pulls society apart in a destructive way. This has been seen most clearly in the financial sector, but it can also be seen in all sectors of society where pay has been used aggressively to motivate top people.

The purpose of the pay cap
The cap is not to get vengeance on bankers, although it might be politically popular for this reason.

The cap is not to raise revenue, although it will free up a lot of revenue in the banks, helping them to recapitalise.

The purpose of the cap is to solve structural problems in executive incentives. It addresses problems in executive motivation.

My recent blog post “bankers’ pay and the financial crisis” shows how performance related pay is profoundly flawed for top bankers because it colludes with a culture which assumes that the banker’s top priority is his/her own personal well-being, most tangibly his/her pay. In other words it encourages the top executive to put his/her own interests ahead of the interests of the company he/she manages. This is a recipe for disaster. Alan Greenspan could not believe that American Banks behaved in ways that were so destructive to themselves. The reason they did this was because the top executives were paid to look out for themselves. I have written a book on performance related pay for top executives (see link “View the book” on the left) but increasingly it seems to me that the goal of alignment between shareholder and executive interests is not realistic because it colludes with selfish desires on the part of managers and does not build a culture in which managers put the company interest first. It undermines the Fiduciary Duty on which our companies’ structures are founded.

A global cap on cap would go a long way towards eliminating selfish financial interests from the motivation of the top people in our banks and other companies. Once you reach the US$500,000 level you can go no further financially. You have to start looking for other forms of motivation. This will create space for more generous motivations orientated towards the good of shareholders, employees, suppliers and customers and towards the wider public good.


Who should NOT be captured by the cap
Wealth creators (entrepreneurs) should not be affected by the pay cap. People who make money by growing their own business, or investing their own money should be encouraged to do so. The cap would imply no extra taxation on capital gains caused by increased business value, and no extra tax on company dividends.

The public can have quite a lot of confidence that entrepreneurs who get rich have done so by creating real value in business (and so hopefully in society). It is much harder to have this confidence about someone who has got rich by being well paid. The entrepreneur makes no money until all employees and suppliers have been paid. Bank loans and corporate taxation must also have been paid. Only after all this money has gone out to other people does money become available for dividends to the business owner. Further the wealth created in this way is critically dependent on the long term success of the business. The incentives are therefore for long term corporate successes. This contrasts sharply with the banking bonus culture which gives rise to incentives which are short term, individualistic and independent of the long term interests of the institution.

Company owners must be encouraged to take their profits out of businesses as dividends not as salaries. Only in the former case can we be sure they are creating business value.


Who should be captured by the cap
The cap on pay should apply to people who are officially working for the interests of others, not for themselves. This certainly includes all company directors and employees. It includes everyone in government.

There are grey areas. Footballers are basically working for others; their club. Pop stars might be working for a record company, or they might have their own record company and be making their own sales. Film stars are probably working for a studio, but they may well be shareholders in their own film companies. Money (or value) received as salary, fees, pay, pension, bonus, share schemes, company cars, perks, etc. should all be captured by the cap. Money received by company owners as dividends should usually not.

Accountants, lawyers and consultants
Any work that requires a fiduciary duty to others should certainly be captured by the cap. Lawyer, accountants and consultants are therefore captured. Partners in big law/consultancy firms should not earn (or take home in profits) more than the cap, even if they are owners of the firm. This is because the same issues about incentives and motivation apply to consultants in respect of their clients, as apply to normal business executives with respect to their shareholders.

Consultants have massive incentives to build large and profitable firms/companies/practices which make money by providing services to other people or companies. Because the money is made by working for others it must be caught in the cap, even though it might be paid out to partners as dividends. This is important because without it consultants have an incentive to increase the scope of their work for the client and to build dependency in their clients. A consultancy business is likely to want to grow its size and profits, but the public need to be satisfied that this is really happening for the benefit of the consultants’ clients, and not just at their expense. One example is computer consultancies who have incentives to sell vast and unrealistic computer projects to governments. Another example is remuneration consultants, as described in Performance and Reward (The book – see link on left) pages 152 to 156. In fact in the case of lawyers, accountants and consultants there is a case for a much lower cap on pay so as to avoid undesirable incentives and to strengthen fiduciary duty.


The problem of loopholes
There is a danger that a great deal of effort and talent will go into looking for loopholes in the pay cap. People will try to restructuring jobs so that they are paid separately by several different companies or in different counties. They will restructure normal pay to look like dividends. They will try to seek pay through their expenses. They will try all manner of tricks. It is very important that all such tricks must fail quickly and firmly.

Loopholes in the cap could be extremely damaging. If executives sense a loophole then very perverse incentives might arise, and very destructive behaviours might be encouraged. Executives must be so clear that there are no loopholes that they do not waste effort looking for them. The law therefore needs to be very strong. I would suggest three aspects:

1) An obligation on companies to be able to demonstrate simply (i.e. without the use of a computer model, or long remuneration reports) that the total value of all their pay to any individual in any period of 365 days does not exceed the cap. The obligation should be so strong that most companies will find that the most convenient way of paying their top employees is a simple cash payment of 1/12th of the cap each month. All value transferred from the company must be included: salary, bonus, share option, pensions, benefits, club memberships, private financial advice, cars, private use of company jet etc..

2) An obligation on individuals not to receive more pay than the cap. Seeking to structure business activities or payment arrangements to avoid the cap must be an offence. Fines for looking for loopholes must be big enough to ensure that there is no incentive to do so.

3) An obligation of tax authorities to search for pay that exceeds the cap, and to tax it at, say 200%.


How will people respond to the cap?
I believe that top executives first reaction will be to look for ways around the cap. This activity must be firmly discouraged, as discussed above. There will also be an increased interest in getting money out of companies through different kinds of fraud. Vigilance must be maintained.

If there appears to be no way round the cap many executives, and bankers in particular, will feel extremely demotivated. There will be a huge motivation problem. The effects of this problem will turn out to be far less serious than they initially appear, because it is only selfish motivation that is being curtailed. Motivations arising from doing things for other people, or because they are worthwhile in themselves will still be retained.

Really talented people, who really do want to get seriously rich will leave employment and establish their own businesses. This will be a very good thing.

Many people who are not so sure that they can make money as entrepreneurs are likely to retire prematurely to enjoy the money they have earned. This will also be a good thing.

People who remain in top jobs will do so because they are interested in the job, because they think it is worthwhile and because they want to do good things for shareholders and other stakeholders. They will be far more ready to prioritise company interests over their own. Fiduciary Duty will be strengthened and companies and institutions will start to look much stronger. This is the real reason for making the change.

There will be increasing interest in making top jobs attractive in ways that do not involve higher pay; shorter working hours, more holidays, and better staff restaurants etc. This will be a good thing.

Several thousand people will have their earnings capped. These people will no longer be competing with each other for better pay. It is likely that they will still compete for reasons of power and prestige, but a great deal of the heat of competition will disappear. Top executives will start to find it easier to work together, easier to like each other and easier to form constructive and rewarding relationships. They will start to enjoy work in a much fuller, more holistic way. New and imaginative collaborations will be born. This will be a good thing.

99.9999% of the global population will earn less than the cap and will not be affected. Many of them will still regard the cap as a very good level of pay and there will still be a lot of competition to get top jobs.

The motivation problem will lead to much simpler business structures and to a much slower and more gentle pace of life in financial centres around the world. GDP will initially fall but this will matter much less than might be expected, because the economic output that disappears will primarily be the output that selfishly favours top people. Its impact on other people will be much less. However, ordinary people will benefit enormously from a more humane and holistic business culture.

Labels: global cap, incentives, motivation