The Rational Case for High Executive Pay

Shareholders are once again in revolt.
Paul Lewis
Mar 02, 2017

As the populist backlash against excessive executive pay picks up momentum the UK government is considering legislation to empower shareholders in decisions over pay awards. Even US President Donald Trump once called CEO pay a ‘complete joke’. For some critics of high pay, it all comes down to questions of greed and inequality. They argue that no-one in any field should be paid so much. Others contend that pay levels for top talent should be left to the ‘free market’ to determine. Both arguments are wrong.

Inequality in itself is a poor reason to oppose high pay. Few object when a successful entrepreneur, whose business wouldn’t even exist but for the personal risks he or she has taken, becomes fabulously wealthy. Instinctively, people know that entrepreneurial wealth is generally deserved. But the ‘market forces’ argument does not hold either, because the so-called market for pay at the highest levels does not function transparently. Intricate mechanisms linking pay to performance are in most cases misleading, allowing some top executives to dissemble about performance.

Myth of talent

The upward ratcheting of pay levels is less the result of better performance metrics, but a function of institutional shareholders endorsing—and indeed personally benefitting from—what has been characterised as ‘the myth of rare talent’. The myth holds that a top manager’s skills are so unusual that unless they are paid their demanded rate they will depart, leaving the company to flounder in the absence of any worthy replacement. A rather different explanation was offered by the economist J.K. Galbraith who observed, that ‘the salary of the chief executive of the large corporation is not a market reward for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself’.

The essential question that investors and corporate leaders must ask is not whether high pay is fair—in either a social or economic sense—but whether in a capitalist system it is rational. In many fields high pay is indeed rational. Consider the top footballer. His performance is very measurable: every pass, shot and tackle is minutely assessed, logged and compared. His club knows exactly what it is paying for. His role in winning games and trophies is to a great degree determinable. And there won’t be too many players in the world who can replace him. Scouts scour the world, including the poorest slums, looking for the next global star. Family contacts, ethnicity or social class is neither barrier to entry nor guarantee of a team place. Only measurable performance matters. So one might reasonably claim that those tiny few who do reach the top genuinely deserve to be there, and their pay will reflect that judgement. In short, the system is open and transparent. Performance is measurable, attributable and largely irreplaceable. It would therefore be rational to set his pay on this basis.

Three strikes

Can the same be said for all highly paid executives? To justify high corporate pay on rational grounds, three simple criteria (as with the footballer or other individual star) should be applied.

  • First, can one measure the executive’s output with any degree of precision?
  • Second, can one measure, with any degree of accuracy, how far that individual’s performance is responsible for the company’s success?
  • Third, is that executive really the only potential person that could deliver this success?

If the answer to all three questions is ‘yes’, then one can fairly state that his high pay is justified. And many high-paid corporate leaders believe it is. Indeed, some justify it by comparing their rare value to that of top sports stars. But does such a comparison work? Imagine the CEO being subjected to a weekly shareholding meeting of some 60,000 ardent shareholders, a TV crew following and discussing his every move—broadcast to millions of armchair investors worldwide—while data analysts crunch the statistics on all his decisions, calculate his impact per minute, and then compare his performance with rivals within the firm and beyond.

We would also have to be sure that the company’s performance—whether good or poor—was driven by the CEO’s decisions rather than by external factors beyond his control such as a booming economy or the success of a legacy product.

And finally, we would have to consider whether he is truly indispensable? Is it feasible that among the scores of departmental and functional heads within a company, and tried and tested managers from outside the business or sector, to say nothing of all the untapped talent pools worldwide, that there are no similarly skilled candidates who with some preparation could not do an equally effective job? Compare the typical leader of a public company—male, white, middle class, over six feet tall, and bearing a prestigious MBA—with successful entrepreneurs, a group that includes a far wider variety of ethnic groups, women and dyslexics. Evidently, some management talent pools remain untapped. So how should companies create a more market-based remuneration system that truly reflects the rarity—or otherwise—of executive talent? Here are some suggestions:

Action points for executives:

  • Over-employ at management level. A tactic used in emerging markets where staff turnover is high, this would generate sufficient supply of talent that could compete eventually for the top job. It’s a medium term plan, but it would help counter claims that the overpaid CEO is indispensable.
  • Change the appointment criteria. When considering applicants for the top job—one that might also carry power and prestige—ask shortlisted candidates to state the lowest amount for which they would be happy to do the job. (The salary probably won’t sink as low as that paid to, say, the US President). Doing this would counter the ratcheting effect of CEO demands to be paid in the upper quartile of their peers.
  • Publish earnings ratio. These can express the ratio between highest salary and the lowest or average wage pay for full time employees. Of course, different sectors will have different ratios, but it could be a useful starting point for debate.
  • Plan for low-pay succession. Offer one final incentive for a departing CEO: find your successor for a fraction of your current rate. This might trigger downward pressure so that pay starts to reflect other senior management jobs such as heading a government department or an international organisation.

Paul Lewis

Editorial Director at Headspring