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Executive Salaries (1)

by Dr Simon Longstaff
19 March 2003
In recent years we have come to see a marked increase in the level of community concern about the issue of executive remuneration. Indeed, a recent visitor from the United Kingdom was heard to ask if this was a particularly Australian phenomenon – a question prompted by a series of stories published by the local press on each of the nine days of her visit!

The recent surge of interest may have been prompted by a couple of well-publicised incidents. As such, the glare of popular outrage is likely to fade over time. However, the underlying issues will continue to be a matter for deeper reflection.

Any attempt to reach a considered position about the ethics of executive remuneration will first need to address a broader set of questions to do with how we reward human effort and ingenuity in general. These questions will need to include a discussion of: how best to measure the relative 'worth' of contributions made by those who contribute their labour rather than their capital to an enterprise, how to make similar assessments of relative 'worth' when comparing the contributions of different employees working within the same organisation and the assumptions about human nature and motivation that underpin the structure of many remuneration packages.

It has been argued by some that payments of many millions of dollars to a few chief executives can be justified on the ground that it is a 'fair share' of the wealth that they have created for the owners. In at least one case, it has been argued that multi-million dollar salaries should be seen as a 'proxy' for the wealth that would have been earned if the senior executive had been able to hold equity in the company that he or she led. After all, why should one business leader, owning equity in the business, make millions of dollars in capital gains while another (working equally hard) is tied to a much smaller salary of, say, only a couple of million dollars a year? Why should a dollar of equity count for more, in the distribution of benefits, than a day of work?

This question lies at the heart of the great debate between capital and labour. Karl Marx was critical of a system in which the owners of capital sought to extract profits from the surplus value generated by the employees of companies in which they invested.

Yet it is not just thinkers, like Marx and his intellectual heirs, who argued that it is unfair that the work of a person's mind and body should count for less in the balance with capital.

Even Adam Smith, much revered as the 'father' of the market economy, looked askance at the demands of owners for what might be considered more than their 'fair share'. Commenting on the way in which certain financial drains can hamper the competitiveness of companies in a free market, Smith observed:

"Our merchants and master manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both at home and abroad. They say nothing concerning the bad effects of high profits [which many shareholders demand as the source of dividends and capital gains]. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people."

The traditional response from those who invest their capital in enterprises has been to make the central point that investors take a much greater financial risk than do employees. While employees (especially senior employees working under contract) can expect the regular payment of wages, investors can go without any return (and even lose the full value of their subscribed capital) if things go poorly for the companies in which they invest.

Investors argue that, when companies perform well, their additional profits are the premium earned for accepting risk. Thus, employees who do not hold equity in a company are mistaken in comparing their wages with the capital gains that might have been earned by those of their peers who invested their own money in the corporations that they led to prosperity.

Some executives are precluded from holding equity – and claim that it is unfair that they should be denied the opportunity to earn sums equivalent to those of their peers who hold equity. However, as we have seen, executives in this position must ultimately appeal to the long and broad historical chain of arguments (Smith, Marx, etc) to support their contention that they be rewarded handsomely for their efforts.
The traditional manager, and even the business leader, must find success through the efforts of others.
However, if executives are to rely on this argument, then they are likely to be asked to explain its selective application in cases where their interests are at stake. Many employees, working within the same businesses, will want to know why there should be so much downward pressure on their wages – with the greatest force for wage control emanating from the office of the CEO. If the argument for 'labour' is so compelling, why should it not apply across the board?

The usual response is to invoke the idea of 'the market' to explain the disparity. Put simply, a global market for executive talent (which is in scarce supply) causes the price for that talent to rise inexorably. The same global market for non-executive talent (of which there is plenty) causes the price for that talent to fall inexorably. The effective consequence of this is that an executive may be paid a sum millions of time greater than another person working in the same company.

It is sometimes argued that the market is 'amoral'; following the laws of supply and demand without any sense of whether or not the outcomes are ‘right’ or ‘wrong’. Thus, the two largest markets in the world are for weapons and illegal drugs. Yet, even if markets or their mechanisms are 'amoral', it does not follow that people are (or should be). Only the ethically desensitised could fail to recognise that the massive variations in remuneration, within some companies, raise important questions. Not the least of these is to do with what it might mean to see businesses as collaborative ventures in which each person plays a vital but distinct role and where each role brings its own particular challenges and opportunities.

A few business leaders begin as entrepreneurs – building great companies from the ground up and usually putting their own capital at risk. In these relatively rare cases, the creative spark that fires up a great business comes from an individual. Yet, even then, the transition from a small to a large enterprise requires the skills of an accomplished manager – usually with skills quite different from those of the entrepreneur – and the assistance of a growing number of employees.

The traditional manager – and even the business leader (quite different types) must find success through the efforts of others. Everybody – from the receptionist to the marketing manager makes a contribution to the overall welfare of the corporation.

This is not to say that the contributions of different people are identical. Clearly, the level of skill, knowledge and understanding needed to perform various roles varies from job to job. And there can be no doubt that some shoulder greater responsibilities than do others – often with a commensurate capacity to affect the destiny of a business.

However, nothing can be drawn from the mere fact of this difference between roles when assessing the relative worth of each contribution. That is, it is still open to the board and management of a business to conclude (if they are minded to do so) that the upper level of remuneration should be limited to a multiple of the amount awarded to the most lowly paid employee in the company. The US company, Ben & Jerry's pursued this policy for many years – using a multiple of five to set the salary of its best paid people.

None of this is meant to say that CEOs should be poorly paid. It would still be open to boards to award multi-million dollar packages to top executives – just as long as all other employees enjoyed correspondingly high levels of remuneration. However, as noted above, the application of a structure like that of 'multiples' would not normally meet the test of being an efficient market mechanism.

In response, it could be argued that there is, in fact, no such thing as an 'amoral' market. Markets are always the mechanism for and the result of an aggregation of choices. Choices (even unreflective choices) are ultimately and always a reflection of peoples' values. That is, one can conceive of a market in which people freely choose to reward all employees within a prescribed band because to do so is a reflection of their values (and therefore, their interests).

It would be understandable if, to many people, this seems a rather improbable kind of labour market to pursue in practice. After all, we have been taught that free markets are driven by the engine of self-interest; with the common good being secured through the influence of the 'invisible hand'. In passing, it should be noted that there is nothing, in principle, that would prevent people from concluding that their self-interest is best served by establishing a market for labour with embedded characteristics of the kind discussed above. After all, no person can declare a market to be economically 'mistaken' in its preferences – even if those preferences are for seemingly artificial constraints like multiple'.

A further set of issues relate to the question of self-interest. Has the engine of self-interest secured too great a place in our thinking? After all, what is 'self-interest'? Can it be reduced to nothing more than an assessment of financial benefits?

The concern here is that too narrow a view of human nature has been allowed to inform the systems and policies for setting remuneration. Some of the biggest payouts to executives have come as a result of options (and other forms of benefit) linked to the attainment of targets designed to represent evidence of adequate (and sometimes superior) future performance.

The basic assumption behind these policies has been that executives (and presumably other employees) will only strive for excellence if the financial incentives to do so are defined and available. Lying at the heart of the standard executive remuneration package of the past decade is a simple idea – people are most likely to strive for success when there's a financial reward for doing so.

The trouble with this approach is that it is constantly falsified (as a general theory about human nature) by the many examples of people who are motivated by quite different reasons for action. Many people seek to excel for no reason other than that: they have promised to do so (when accepting employment), they love their work, they are committed to attaining excellence – to mastering their craft.

The one-dimensional view of people as homo-economicus just doesn't line up with contemporary or historical experience in which the building of great companies proceeded without an executive share option plan as the golden carrot used to encourage 'real' commitment. One can but wonder what it does to a human institution (like a business) when people give up on the challenge of inspiring each other in favour of buying commitment with the prospect of future gains.

All of this ignores the fact that most of the recent anger has been directed at boards and senior executives after revelations of huge payments to people who have presided over the destruction of vast amounts of value. In some cases, the departing executives insist that they receive the full value of their remuneration (as outlined in their contracts) even though they have led a process resulting in virtually every other stakeholder having to pay the price for failure by the corporation.

However, it is no longer simply the case that members of the public are expressing dismay about large payments to those who have failed to meet expectations. There is also an underlying concern about the payments made to successful business leaders. Just how much is 'enough'? Is it really the case that people currently running major Australian corporations are motivated by the size of their pay cheque rather than the challenge and opportunities of the role? How would people choose if their pay were capped at one or two million a year?

Then there are questions about the judgements Australians make about business people when compared to top-tier sporting and creative talents. Why do we criticise executives but remain silent about the millions earned by David Beckham? Why is it accepted that Mick Jagger can be a multi-millionaire – but not the head of a major Australian company operating in the global market? The different approach to business could be explained in a number of ways.

First, it might be that people do not equate business leadership with the kind of excellence exhibited by a Tiger Woods or Elton John. Each is a 'world class talent' – why not accord great business leaders the same accolade and remunerate them accordingly?

Or could it be that we undervalue the actual contribution made by each business leader on an individual basis – undervaluing skills, creativity, risk and engagement? Is our antipathy to business leaders part of a deeper antipathy to business as something less uplifting than sport or art? Is this a fair assessment or the last echo of an ancient prejudice against the merchant classes? Is money generated by business seen as more vulgar than that generated by other pursuits? Would things be different if more people thought that business made a significant contribution to the welfare of the community as a whole?
Dr Simon Longstaff AO is Executive Director of St James Ethics Centre.