Perils of paying CEOs too much: When shareholders say no

Shareholders are rejecting proposals to ramp up CEOs’ rewards

Chief executives' outsized pay packages are again coming under scrutiny, following a host of controversial pay awards in recent weeks. A fortnight ago, 59 per cent of BP shareholders revolted against the $19.6 million (€17.28 million) pay deal awarded to chief executive Bob Dudley. Shareholders were upset over a 20 per cent pay increase in a year that saw the company announce thousands of job cuts as well as record net losses of $6.5 billion.

On the same day, a majority of shareholders at another FTSE 100 firm, medical equipment group Smith & Nephew, voted against the decision to award bonuses worth £2.1 million (€2.66 million) to senior management, even though shares in the company had lagged its peers over the previous year.

Last week, Sir Martin Sorrell, founder and chief executive of advertising giant WPP, launched an unapologetic defence of his £63 million pay package, the second-biggest ever awarded to a FTSE 100 chief. Sorrell's pay deals have previously come under fire from influential advisory group Institutional Shareholder Services (ISS), which last week voted against the £3.4 million awarded to Mark Cutifani, the chief executive of beleaguered mining outfit Anglo American.

ISS, also at the centre of the BP shareholder revolt, has urged shareholders to rebel against executive pay awards once again at this Thursday's annual general meeting of Dublin-based pharmaceutical giant Shire; its chief executive Flemming Ornskov's compensation package rose fivefold last year, to $21.6 million.


HSBC, AstraZeneca, Reckitt Benckiser and Centrica have seen similar expressions of shareholder discontent, fuelling talk of another "shareholder spring" akin to 2012, when a number of high-profile executives quit under pressure from disgruntled shareholders.

Growth in pay

The average FTSE 100 chief executive earned £4.96 million in 2014, according to the High Pay Centre, or 183 times the salary of the average British worker. In the US, the equivalent ratio is over 300:1, according to the labour-backed Economic Policy Institute, compared to just 20:1 in 1965. Back then, chief executives were well-paid salaried professionals – "like bureaucrats", as Harvard economist Michael Jensen complained in 1990 – who were paid "virtually independent of performance". Jensen provided intellectual backing for the idea that generous stock option packages were needed to produce "value-maximising entrepreneurs". Chief executive pay skyrocketed in the 1990s.

Since the 2008-2009 global financial crisis, however, this thesis has become increasingly unfashionable. In 2010, Sir Richard Lambert, the then head of the Confederation of British Industry (CBI) and a former editor of the Financial Times, warned chief executives "risked being treated as aliens" due to their remuneration packages.

Last-chance saloon

Following the recent shareholder rebellion at BP, the Institute of Directors said British boards “are now in the last-chance saloon”, warning the UK government would introduce tougher regulations on executive pay if shareholder discontent was ignored.

In the US, public companies will have to disclose the ratio of chief executives’ pay to that of employees from next January.

Evidence is mixed as to whether financial incentives for chief executives boost company fortunes. One 2014 study found that investors earned much bigger returns from companies where the chief executives had high levels of stock ownership.

However, although this might suggest executives should be awarded more company stock, the study focused on chief executives who owned at least 5 per cent of company and it would, the authors noted, “simply be too expensive for a firm to give its managers such high ownership stakes as part of their compensation contracts”.

Excess compensation

Other studies are less supportive. One 2006 paper found "excess compensation (both of directors and chief executives) is associated with underperformance", concluding that high pay awards were "due to mutual back-scratching or cronyism". A 2014 paper, entitled Performance for Pay? The Relation between CEO Incentive Compensation and Future Stock Price Performance, found the top-paying decile of companies were among the worst performers over the following three years.

The British experience is similar, according to a 2014 paper, CEO Compensation and Future Shareholder Returns: Evidence from the London Stock Exchange. Firms with the lowest chief executive incentives "significantly" outperformed the top-paying companies over the 1998-2010 period, both in terms of future shareholder returns and operating performance.

More damning, perhaps, is research from University of Chicago professor Marianne Bertrand showing that companies have historically rewarded executives for beneficial outcomes associated with luck rather than chief executives skill. Her 2001 paper, Are CEOs Rewarded for Luck? The Ones Without Principals Are, documented the pay-for-luck phenomenon, noting how oil executives tended to get pay rises when global oil prices improved while chief executives at multinational companies received pay hikes when company fortunes improved with random currency fluctuations.

Ironically, the importance of bad luck can also be used to justify executive pay packages. BP defended Dudley’s pay hike on the grounds it was associated with improvements made on safety, project management and cost-cutting, rather than oil-price-related losses “over which executives have no control”. To guard against the pay-for-luck tendency, Bertrand has suggested more outsiders be appointed to company boards as well as indexing company performance to that of other firms in the same industry.

The latter case is frequently made by WPP's Sir Martin Sorrell, who is never shy of pointing out that the firm has handsomely outperformed rivals in recent years. Fast-food firm Chipotle recently announced future chief executives' compensation would be linked partly to share price performance, a move also made by computer chip maker Qualcomm following pressure from activist hedge fund Jana Partners.

However, others suggest different performance metrics be used, arguing too much focus on share prices incentivises chief executives to prioritise short-term measures designed to juice stock prices higher.

Abolishing bonuses

A more radical alternative would be to revert to the pre-1980s environment and abolish bonuses entirely. Not all chief executives are aghast at such a notion; last November, Deutsche Bank head John Cryan said he had "no idea" why he was offered a bonus-focused contract, saying it would not make him "work any harder or any less hard in any year".

The case for fixed salaries was recently advanced by London Business School academics Dan Cable and Freek Vermuellen in the Harvard Business Review. They say there is "no compelling evidence" that companies ultimately benefit from bonus-focused arrangements.

They point to research suggesting big performance incentives work only for routine tasks, but not for people working on “creative tasks – where innovative, non-standard solutions are needed”. In fact, “fixating on performance can weaken it”, according to Cable and Vermuellen, citing research showing that salespeople with a learning mindset outperformed those with a performance-oriented attitude, as well as recent evidence that creativity among consultants improved when they focused on learning rather than results.

Additionally, people perform better when they are intrinsically motivated – that is, when they do things for their own satisfaction – as opposed to when they are extrinsically motivated by financial reward. Financial incentives increase extrinsic motivation but diminish intrinsic motivation, as “conclusively” shown by a meta-analysis of 128 independent studies.

Paying for performance can also lead to executives cooking the books: the London Business School pair cite different studies linking the award of stock options to increased earnings manipulations, shareholder lawsuits and product safety problems. “When people’s remuneration depends strongly on a financial measure,” they said, “they are going to maximise their performance on that measure; no matter how.”

Ultimately, whatever measurement system is used will be a flawed one; when people are rewarded for one measure, it will be prioritised to the detriment of activities that are not rewarded.

Chief executives are unlikely to sign up for such a vision any time soon, citing the competitive global marketplace and the thesis that incentives are good for shareholders as well as for executives. Cable and Vermuellen agree financial incentives are important determinants of chief executive behaviour. However, “it will not be in a way you want them to behave”, they caution.