A time travelled reward strategy; Who?

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Introduction

I was listening to the excellent “Dr Who at the Proms” on the radio.  The music was evocative of different times and alien terrains.   A thought struck me; what would the reward landscape look like in ten years’ time? Two alternative possibilities collided in my mind: a sort of Matrix like choice of different futures, a red pill or a blue pill? These were:

  • A continuation of what had gone before with ever increasing inequality between high and low paid
  • A more equal, transparent approach with some convergence between the levels.

This article will be looking at the outcomes of these two scenarios and the different pressures that may lead to one or the other becoming the new reward reality.

Continuation of the status quo

A troika of forces support the status quo.

  • The self-interest and power of those who benefit from the current system
  • A lack of political will to make changes; perhaps connected to first point.
  • As the economy improves the supply and demand equation will reassert itself.

There is a large amount of vested interest in the status quo.  This is not only from the direct beneficiaries of high pay; but also from those who benefit indirectly.  The barrier between board rooms and politicians together with senior public servants has always been porous.   Politicians and public servants often move in to corporate board rooms following retirement from “public service”.  It may be argued that waiting for those who currently hold the levers of power to reduce their future earnings potential in the private sector is like turkeys voting for Christmas; unlikely to happen.

Although outside the parameters of this article there is some interesting research to be undertaken on the issues of power and ideology as they relate to the economics of reward.

Even when the global economy is in recession it is difficult to attract the right calibre of staff in to executive management positions.  Or, if we look at the highest paying sector (putting aside football players and those in the entertainment industry), in to investment banking.   Getting the right people in role can make a great difference to organisational and financial success. When Stephen Hester was unexpectedly removed as CEO of RBS, its share price fell by about 7%.   At the top levels it is a seller’s market, with, arguably, an increasing international dimension.  There is anecdotal evidence that top mangers’ prefer moving in to private equity where rewards are higher but less transparent.  Likewise the increasing, and in my view, mistaken, prescriptive approach by the USA, EU and regulators on financial services pay, has the potential to lead to a flight of talent to less regulated shores; much the same as we have seen in the past with corporate tax planning.  This means a race to the top for the best talent with organisations worried about falling behind their competitors; the stairway is to heaven for the high paid.

There are considerable forces of inertia to be overcome before we can travel to a more progressive pay landscape.

What will the status quo pay landscape look like?  I used some data from the excellent MM&K survey of executive pay to develop a model.  The current position in the UK FTSE 100 (the UK top 100 companies by capitalisation) is:

  • Average FTSE 100 CEO remuneration:       £4,516,474
  • Average FTSE employee pay:                       £        33,957
  • Ratio of employee to CEO pay                                    133

If we look at the last ten years, the average increase in CEO remuneration has been 5.8% and 3.9% for employees.  I build a Monte Carlo simulation (with a heroic assumption that the increases were normally distributed and appreciating that ten data points is not a good sample) that showed there was a 50% probability that the following would occur;

  • In 2022 average FTSE 100 CEO remuneration:        £7,972,054
  • In 2022 average FRSE employee pay:                       £      49,668
  • 2022 ratio of employee to CED    pay                                       161

So inequality between those at the top of the pay scale and those on the average wage would get progressively worse.  A “Hunger Games” scenario with a large population of lower paid supporting a small population of very high paid.

There is a counter argument to this approach.  As the Institute of Fiscal Studies reports:

“Income inequality in the UK fell sharply in 2010–11. The widely-used Gini coefficient fell from 0.36

to 0.34. This is the largest one-year fall since at least 1962, returning the Gini coefficient to below

its level in 1997–98. Although this reverses the increase in this measure of income inequality that

occurred under the previous Labour government, it still leaves it much higher than before the

substantial increases that occurred during the 1980s”.

Thus, income inequality is a moveable feast with volatility making it difficult to confirm a consistent trend given the constant transformations of the tax and social security structures.

A more equal, transparent approach with some convergence between the levels.

There are a number of important pressures that indicate that this is the more likely outcome; albeit occurring over a long period.  As Jon Terry of PwC, a globally recognised FS reward expert, notes they can be broken down in to three broad areas:

  • External pressures
    • Pressure from shareholders
    • Pressure from the regulators
    • Economics
    • Cultural pressures

External pressures

I had a very interesting conversation with Cliff Weight, another internationally recognised reward expert, from MM&K.  This was on the subject of the balance of power between shareholders and executive management.  It is my view that in the past shareholders were more relaxed about the quantum of pay. This is because they were making a good return on their equity.  That situation has now changed.  Return on equity has, in many sectors, reduced considerably.  At the same time the percentage being spent on executive remuneration has risen.  Shareholders are now taking a much more detailed interest in the balance between what they earn and what the “talent” gets paid as a percentage of revenue.

It is also worth mentioning the role, particularly in the US but increasingly in other countries, of the activities of shareholder advocacy groups such as Institutional Shareholder Services (ISS).  I am not a fan of their somewhat tick box approach; but I fully appreciate that they do an important job in highlighting what may be seen by some, as poor pay practice.  Institutional shareholders are increasingly (although perhaps wrongly) relying on the advice given by these organisations.  The pressure on pay is always downwards.

A similar downward pressure is beginning to be exerted by the regulators; albeit often accompanied by prescriptive, counterintuitive and sometimes downright stupid regulations. There is a good summary of the latest UK regime on remuneration reporting here.  A downward pressure on remuneration by regulators is a clear and present danger to the maintenance of the status quo.  Linked to this are the regulatory requirements, initially in financial services, but likely to move to other industries, to hold sufficient risk based capital to support operations in the event of black swans, unlikely but catastrophic events.   This reduces the risk capital that can be invested in higher risk; higher return activities, so, picking up the issue in the paragraph above, reducing the potential returns to shareholders.

Economics

There are two opposing economic pressures affecting this debate.  Shareholder returns are dropping, as discussed above.  There are structural changes taking place that indicate that we may never see a return to the fifteen per cent plus returns before the financial crisis.  If that is the case there is going to be considerable downward pressure on remuneration in order to ensure a more “equitable” division of return between capital providers and employees.  The counter argument is that if there is a return to high inflation (and that has a high possibility in my view) and good economic growth, there is the likelihood of higher relative returns, while the scramble for labour intensifies and earnings at the top of the ladder explode.

Currently the balance appears to be in favour of the economic constraints on equity return leading to downward pressure.  But, as previous booms and busts have shown little is impossible, even if very improbable.

Cultural pressures

This is the most interesting of the downward pressures on pay.  I discussed this issue extensively with Cliff and Jon.  There is a clear consensus between the three of us that there are strong undercurrents of social pressure to increase transparency and have a more equitable distribution of pay.

These pressures are coming from all levels and in some cases some unexpected directions.  We are currently seeing the senior executives of some large organisations preaching pay restraint and greater responsibility.  Although, as the recent CIPD report on “Rebuilding trust in the City” (of London) shows there is a long way to go and some leaders still work on the basis of do not do what I do, do as I say.  But, this apparent change by the changing leadership of some large organisations is an interesting trend.

It can also be argued that those currently coming in to the system or beginning the climb up the greasy pole of corporate life have a different approach to reward, work and life balance.  Perhaps there is something less of a drive for personal gain and more a realisation of the importance of social contribution; we can but hope.

I am unsure that issues of high pay have yet entered the popular consciousness; a bit like the zombies in “World War Z”; we know they are bad but we are not going to come across one in real life.  Very few people have even indirect experience of high pay either in an absolute or relative sense.  Thus, while there is a broad sense of moral outrage driven by an often misinformed media; there is a limited popular demand for restraint on high pay and even less of an understanding of labour market economics or the complex nature of senior reward.

Having said that, social pressures are leading to what Jon Terry described as a “noticeable shift” in attitude by those both at the top of the tree and those who are working their way up the branches.  It is not yet revolution but is most certainly evolution.

What is clear is that social pressure is building up a head of steam and will have, perhaps, a defining effect on the reward landscape a decade hence.

Conclusion

My travel in to the future of reward is complete.  The evidence supports the scenario that in ten years’ time we will have a more transparent, more equal, reward landscape.  It is also likely to be an extremely regulated environment, particularly for high pay.  The issue is that state intervention starts to look like pay policy and pay policy, as history has shown, seldom works and discourages an open market in reward with frequent unintended consequences.

Executive Directors, consultants, remuneration committees, regulators and last but not least, reward professionals must start to prepare themselves for the changes that are beginning to appear on the horizon of the reward landscape.  It must be acknowledged that the future seldom turns out the way we expect; but there are sufficient broad trends emerging to at least give a probability of a more equal approach on pay.  In some ways this becomes a self-fulfilling prophecy.  If we start to think and prepare for a more transparent and equal pay environment it is more likely to happen.

Acknowledgements

I would like to thank two globally recognised reward experts, Jon Terry of PwC and Cliff Weight of MM&K for sharing their insights on the subject with me.  However, all the views expressed in this article are mine alone.

Complexities of reward

My wife and I like to work together to solve the Telegraph quick crossword on my ipad, we are not good enough yet to attempt the cryptic crossword. We like crosswords as they test our knowledge but also because you can go off down the wrong path very easily and not realise it until that last clue where you know the answer but it does not fit in the grid because of an earlier wrong answer.
Reward is like this in many ways. It is moving from being the quick puzzle to being a very cryptic crossword where mistakes can be made and not discovered until a long way in to the process or product design. It has become apparent to me that Reward is at a crossroads, in the middle of a maze. There are now so many stakeholders involved, employees, management, compensation committees, regulators shareholder advocacy groups, trade unions and politicians it is difficult to know which way to turn. They all have different viewpoints, different agendas different understandings and different needs.
There is a lack of common ground, common language and common definitions. What, after all is high pay or low pay for that matter? Are we looking at absolute or relative levels of pay? Are we comparing with some mystery average or mean? As a result what looks fair and reasonable to a Compensation Committee looks like highway robbery to a trade union. The area is fought with paradox. We can see these paradoxes at work in the controversy over BBC pay for talent. Because the BBC is funded by licence payers there is the application of a different standard for, say Jeremy Clarkson, than there would be if he worked for a privately funded broadcaster. Yet the labour market in which he operates is exactly the same. Is he supposed to be happy to earn less because he works for the BBC? Would we be happy to be paid less because we work in the public sector, and judging by the latest earning statistics for those in the public sector vs. the private sector the answer to that is a clear no.
What we and others are paid is very important; yet there is no overarching theory on pay and reward. There are attempts such as the excellent tournament theory or expectation theory for example. Labour market economists will talk about supply and demand – but that is not the entire story. Behavioural economics are increasing playing a part in pay theory. Yet, like Steven Hawkins attempt at a grand unifying theory we are really nowhere near achieving a consensus on what is fair pay.
So reward specialist have the issue of not only undertaking complex work on pensions, share options, taxation, total reward, flexible benefits, accounting standards, compensation disclosure rules and the like but we have to be able to justify our recommendations before the court of public opinion, political scrutiny and regulatory microscopes. Often with the benefit of 20 20 hindsight.
There are two concerns around the complexity. The first is that there are very few individuals who can move between the technically complex and the “public relations” facets of current reward activities. Second, only the larger companies have the resources and time to fully fulfil the requirements, demands and disclosures needed by the stakeholders, Reward normally sits in HR, yet it has strong interfaces with Finance, investor relation, Risk and Compliance, to name but a few.
Perhaps a new breed of expert will appear phoenix like from the current ashes of the shareholder spring; but somehow I think we will just muddle along as always, relying on expensive consultancies