Time to recalibrate CEO performance pay

Just as the whales return from Byron Bay to Antarctica after Bluesfest and the blue bottles return to the beach in time for first surf of the season, executive compensation returns to the headlines every year in time for Annual General Meeting season. It’s reassuring that after 30 years we can read reports voicing the same outrage about so-called pay for performance that they did in 1990. But of course, the examples keep coming.

Take ex-Volkswagen boss Martin Winterkorn, who resigned in September 2015. VW made a provision of $25 billion for the Dieselgate scandal that happened under his watch. Martin made $25 million for leaving, most of which was pay for performance bonuses.

In the US, chief executive officers of America’s largest firms earn 270 times the pay of a typical worker; in the UK, it’s about 180 times. But a study from the David Eccles School of Business at the University of Utah found that “CEOs who receive higher incentive pay often lead their companies to decreased financial performance” and that the “highest-paid CEOs earn significantly lower stock returns for up to three years”. The study also found that CEOs who receive high pay often have longer tenure and have consistently worse long-term returns by approximately 12 per cent.

Research by the Swiss behavioural economist and neuroeconomist Professor Ernst Fehr found “there is, on average, no discernible relationship between executive pay and company performance – suggesting that executives generally reward themselves regardless of whether they succeed or fail”.

It used to be that Australians became wealthy by being entrepreneurs and risking their own capital and homes, or by inheriting money, land and businesses. But over the past 30 years we have seen the rise of a new class of wealthy multi-multimillionaires who are employees. Encouraged by public disclosure of executive remuneration, the white-collar race for money was best described by Tom Wolfe in Bonfire of the Vanities: “How the stories circulated on every campus! If you weren’t making $250,000 a year within five years, then you were either grossly stupid or grossly lazy ... By age 30, $500,000 – and that sum had the taint of the mediocre. By age 40 you were either making a million a year or you were timid and incompetent.” John Churchill, former Sydney law firm managing partner and now adviser to CEOs on employment contracts and terms, says “over the past 25 years public companies have created enormous wealth for senior executives. They can make tens of millions with no risk except losing their job. They don’t have to invest their capital, they don’t have to employ staff or mortgage their houses, and they have a safety net so they are earning risk-free returns.

“Many boards, driven by disclosure to align pay to shareholders’ interests, have outsourced their responsibility on executive pay to the remuneration report. Performance pay is awarded regardless of performance.” Thirty years ago, Michael Jensen and Kevin Murphypublished the results of their research on CEO pay in the Harvard Business Review. “There are serious problems with CEO compensation, but ‘excessive’ pay is not the biggest issue,” they wrote. “The relentless focus on how much CEOs are paid diverts public attention from the real problem – how CEOs are paid. In most publicly held companies, the compensation of top executives is virtually independent of performance.

“Shareholders rely on CEOs to adopt policies that maximise the value of their shares. Like other human beings, however, CEOs tend to engage in activities that increase their own wellbeing. One of the most critical roles of the board of directors is to create incentives that make it in the CEO’s best interest to do what’s in the shareholders’ best interests.” The Australian pool of talented executives who can run truly competitive companies of scale is very small. Add those who can run successful companies globally and that list gets down to three or four. And it’s a high-wire act. Senior executives have fewer rights than factory floor workers and can get fired at the whim of a board. In fact, superior performance is no guarantee of job security. Once a high-profile executive has been fired, his or her mainstream career is over.Part of the answer, as Jensen and Murphy wrote, is to structure cash compensation “to provide big rewards for outstanding performance and meaningful penalties for poor performance. The threat of dismissal for poor performance can be made real”. Other than that, this is a genie that ain’t going back in the bottle.

Julie Connolly