The Market: What Market?
It is a truth universally acknowledged that a well- run organisation has an effective leader. Good CEOs deserve to be well rewarded.
Forty years ago, there was a consensus emerging in Europe that pay differentials should be around 5:1 (gross) from top to bottom in any organization. While that was shown to be unworkable, today we have more like 500:1, and climbing. How did this happen?
1. The Morality of ‘Enough’
In 1997, Charles Handy wrote, “A society that does not recognise the morality of ‘enough’ will see excesses arise which verge on the obscene, as those who have the first choice of society’s riches appropriate them for themselves. Democracy will not tolerate such an abuse of the market…When senior executives of companies earn fifty, sometimes even one hundred, times the pay of their own workers, it is hard not to feel that is an affront to those workers”. Yet it seems our moral sensitivity has been so bludgeoned by the pillage and plunder at the top of both private and public sector organizations that twenty years’ later, Handy’s admonition on the danger and extent of ‘excess’ seem almost quaint.
Ed Lawler, the US reward guru wrote, “The core reward principles that an organisation develops should represent a standard for the organisation – that is the organisation should always test its behaviour against them.” In 2012, Michael Sandel picked up the same theme as Handy and Lawler: “Markets have become detached from morals and we need somehow to reconnect them.” Rather obvious of course but try telling self-serving investment bankers that in 2016.
2. When did today’s escalation in pay start and what caused it?
As good a place as any to start is 1974, when the Diamond Commission was set up in the UK by the Labour Government to examine the distribution of wealth of those earning £10,000 or more whether employed or in self-employment. It was felt then that a ratio of 5:1 gross from the top earner to the lowest employee should be the norm. Similar ideas were canvassed in the French Sudreau report at the time and were gaining favour in The Netherlands, Denmark and Sweden. The only social democratic group out of step was in Germany where Willy Brandt referred to these ideas as “Kindergarten economics.”
3. Developments post Diamond
3.1 The erosion of the importance of performance pay
One of the insidious impacts of Diamond and the Labour Government’s executive pay freeze in the 1970s was the beginning of the erosion of the importance of pay for performance. Rocketing inflation saw managers’ standard of living falling very quickly. Not much ingenuity was required to introduce a raft of tax effective fringe benefits to protect living standards. During this period the incidence of the car benefit rapidly increased in the UK and reached much further down into management layers than in Germany for example. Education allowances were introduced, travel subsidies, ‘working clothes’ (suits) and so on. If, as was the case, benefits are given to all management, irrespective of their performance, it is self-evident this undermines the philosophy of “pay for performance,” which was a fundamental principle stated in management remuneration policies of the day.
3.2 The undermining of the need for market measurement
It also led to the first subtle undermining of the need for accurate assessment of the market since this was becoming irrelevant in an era when fringe benefits ruled and cost of living payments outreached merit percentages as inflation reached 26%. Since performance was not the key factor influencing the level of individual reward, market measurement to establish competitiveness was not so critical. This only began to reverse when the Thatcher government started to tax individual benefits in line with their income tax level. That encouraged the payment of salaries rather than the extensive awarding of benefits, which in turn made the collection of taxes more straightforward for the government and in theory put greater focus on merit. But just as life was returning to ‘normal’ with less dramatic levels of inflation another tremor hit the London and UK executive pay markets.
3.3 The Big Bang in London
The Big Bang refers to the day of deregulation for the securities market in London on Oct. 27, 1986, in which the London Stock Exchange (LSE) became a private limited company. The Big Bang witnessed many changes in the financial markets, including the removal of fixed commission charges, the distinction between stockbrokers and stockjobbers, and the switch from open-outcry to electronic trading. The changes led to large banks taking over old firms. It was part of the U.K. government’s reform program aimed at the elimination of the city’s major problems: overregulation and the widespread influence of old boy networks. It was predicated on the doctrines of free market competition and meritocracy.
3.4 The consequences of Big Bang
Although the Big Bang triggered some beneficial changes it also had some negative effects. Due to the deregulation of the markets, the concentration of power was focused on the big companies that took over long-standing small, often family, firms. This same change created by the Big Bang trickled throughout the financial systems around the world. Now, companies that are “too big to fail” dominate financial cities, which led to the Great Recession of 2008. But more relevant to this topic, Big Bang started to erode further the disciplines underpinning the measurement of market pay for individuals. For the first time, I encountered reward managers in the large banks that had gobbled up the small family firms in the late 80s, on recruitment drives talking of the “the need to pay the market rate.” One group in short supply at this time was accountants, whose pay started to reflect the increased competition. Yet beyond this simplistic belief that every job or person had a specific “market rate” I was shocked to notice that the ‘science’ behind this talk of the market was a reality that said in effect, “We have to pay that because this is what he (then, still invariably he) wants. So, that is what he is worth. That is his market rate.” When I asked: “What is the margin of error in your assessment?” I was lucky to get so much as a blank stare.
It was sloppy work by the reward profession, which helped unleash the start of a free for all in financial services that has continued to accelerate since. There was allegedly a shortage of ‘talent’, rarely defined or rigorously assessed, which contributed to an erosion of market measurement disciplines.
3.5 The erosion of skill and techniques needed to reliably asses the market
My mentor in the 70s, Philip Clemow a qualitied mathematician and actuary, taught me the basics concerning the statistical validity needed to reliably measure a particular executive reward market. If one was attempting to measure a national market, such as the UK, the composition of the panel was the critical foundation. It was important to have at least one leading payer from all the key industries, with each being of comparable size, complexity and taking a professional approach to assessing the accountability of roles and their consequent reward levels. It was also a requirement to change a couple of companies within the panel each year to protect the reliability of the sample. Following the Big Bang, financial institutions first broke this fundamental rule of statistical reliability by setting up a club of similar companies in the one industry only, which measured only a small part of the executive market in the UK. It predictably led to gross pay distortions, as will be shown below.
The effective approach was to survey a wide cross section of job types (families) and at different layers across the company. Thus, one could establish the following table illustrating the known degree of statistical error of varying samples.
Maximum error of market position as a % of the comparator company’s salary level
For example, as set out in Table 1, a sample of 5 jobs from 5 banks could at best yield a result that was either 7% above the market or 7% below. Such a spread of 14% was worse than useless. The trouble was many reward managers seemed to be oblivious of this.
Table 1 also shows that a mix of 30 jobs across at least 20 different companies in different industries is a totally reliable measure of a national market since the error rate is well within acceptable statistical error at 1.2: see table 1. The next critical variable is the number and mix of jobs, across different levels which, after a certain point provides greater significance than the number of companies. Thus, for example a sample limited to 15 companies with at least 20 jobs per company would give an result within +/- 2%, which is statistically acceptable.
In recent years, probably the worst example of this breakdown in statistical orthodoxy has been in financial services where a favoured consultant’s survey consisted of only companies such as banks. This was in fact a club spiralling upwards without a valid connection to the real market in the UK. This coupled with docile (statistically illiterate?) remuneration committees (remcos), provided the “evidence” needed to award ever more grotesque pay increases. They were (deliberately?) spiralling upwards, disconnected from the real management market in the UK. The people talking about ‘measuring the market rate’ mentioned in 3.4 were only approximating a measurement of the market, because their method, taking a reading of only a small slice of the total market, was unsound. History and statistical theory suggests this club quickly becomes a separate rogue market. In this way, the sub ‘market’ exists as a separate segment and drives ‘club salaries’ up (they could in theory go down but that tends not to happen given the objective of the ‘club’) and then takes on a life of its own. This sub market continues to ratchet rates upwards as a manager in it now expects a certain amount for his/her job – more than managers in other industries – and has the option to move to a competitor if not paid according to that expectation. The inflationary genie is then out of the bottle of statistical rectitude.
Pressure for better rewards is not new. Professional ineptitude is.
In 2009 I undertook a survey of management base pay in the UK for a client that aimed to be at or near the top of its industry (and was) but which suspected financial companies were paying well above the UK management market. I had a sample of pay from over 20,000 jobs in the financial sector covering Work Levels 1 to 5 . This revealed that the median of the financial services market base pay was indeed around 30% higher than my client and the trend line indicated the rate of progression was ever upwards. And just imagine the effect of that on the multipliers used for bonus payments, long term “incentives” et al by these banks. This example illustrates how quickly unprofessional statistical surveys can distort the reading of a given market, whether intentional or otherwise, where “damn lies” become the norm.
Within 20 years the banking market had shot up well ahead of other companies in the UK primarily because of the unprofessional way it was measured. Was this justified? What was so special about banking jobs? In truth, very little, certainly not enough to justify the market gap. Most jobs in a bank across for example IT, HR, finance, tax, treasury, market research to name but a few, clearly do not warrant a premium. They are common to the national market. And candidates were not really in short supply despite the mythology of a war for talent. Added to which the few jobs that were specific to the industry were exposed by the Global Financial Crisis (GFC) selling bundles of securities they did not understand. One cannot imagine the management of an oil, consumer goods, pharmaceutical or car company being so ignorant of their own products. Finally, my fieldwork since 2003 revealed UK banks were the most consistently over managed, excessively layered, bureaucratic, wasteful organizations in the private sector. The logic for any sort of premium based on performance or shortage of talent in the sector was wafer thin at best.
The banking pay bubble is real but artificial and unjustified.
4 The onset of variable pay for executives
The next significant development accelerating the climb to steeple high differentials was the onset of variable pay, which started to come into Europe via the UK in the 1990s. The US market had been awash with variable pay and long term payments for quite some time prior to that. This, was probably another trickledown result of Big Bang coupled with more international companies coming into London increasing the mobility of management it encouraged, as Kressler has argued. Thus ‘the bonus’ began to become established in London headquartered companies, especially those in Financial services, initially. At broadly the same time companies started to identify international cadres of usually, top managers who increasingly argued they were in an international market and therefore should have rewards based on international relativity. For example, in 2002 BP, then the second largest company in the UK announced its CEO had been given a rise of 72% (his workers had been offered increases of 3% during the same period when 1,000 jobs were deleted.) His salary and bonuses rose from £1.8m to £3.1m, leaving aside share options of another £2.6m, his earnings were already more than 100 times the national average. When asked to justify such an obscene increase the company explained this decision was based on a comparison with the largest oil company in the world, ExxonMobil, (obviously not a relevant or fair benchmark, being much larger and more complex than BP) that paid its CEO £22m the previous year – a figure that included non-salary items! BP also pointed out their CEO was a long way behind Britain’s top earner at Vodafone (only no. 3 in the UK), so the increase was ‘justified’ by market relativities. A classic case of an inability to identify truly relevant and accurate benchmarks. This was NOT an international market at the time: e.g. does anyone really believe Exxon would have looked inside BP for a successor to its CEO? This stardust logic was apparently accepted and swallowed whole by shareholders as the BP CEO’s pay went through on the nod. This ineffectual process has not been helped by some questionable governance initiatives in the field of reward management – see 4.6 below.
4.1 The history of variable pay
Variable pay originally applied to blue collar work in early 20th century where quantity and quality of work was easily and immediately measurable. (This is not so evident today in relation to top pay.) It was the child of industrial mass production and the insights of so-called Scientific Management with its time and motion studies calling for subordination and conformity to the machine, not individuality and innovation. Workers in factories and offices had no impact on the design of the processes underpinning their work. Time and motion studies gave way in time to systems analysis, operations research, process engineering and latterly the cyber world of information and digital technology. So well into the 2nd half of the 20th century variable pay was a feature of unskilled and semi-skilled work. But by the mid-1980s the approach to management variable pay that emerged in the US in the 1970s had migrated to Europe. It was underpinned by three myths: the entrepreneurial myth, the incentive myth, and the market myth (see 4.2 to 4.5 below). Initially the bonus element in Europe represented 10 or maybe as much as 20% of salary but by the end of the 20th/beginning of the 21st century the levels were already being expressed in multiples of base salary.
4.2 The entrepreneurial myth
By this time, businesses were increasingly run not by owner-managers and entrepreneurs but by professionals with employment contracts. A need and desire for a new ‘dynamism’ after the difficult 70s & 80s following the growth years of the 60s, gave rise to so-called entrepreneurial pay policies. It was then argued that the earlier practice of a fixed salary and key perquisites such as a company car, was not the kind of guaranteed reward an entrepreneur would expect. Rather, if entrepreneurial behaviour was sought then manager-employees should have part of their income at risk, as had been the case with salesmen. This reinforced thinking about paying a bonus in addition to the management salary, since that part of the reward package would be “at risk” and would therefore drive higher performance, achievement and innovation. Within a decade this logic saw the emergence of share schemes and options based on the logic of “variableness is a good thing” if the aim is entrepreneurial leadership and innovation. Gifford Pinchot even invented the term “intrapreneur” for an entrepreneur inside an organization. For others, this was a meaningless contradiction in terms. The desire for money can father many illegitimate offspring.
4.3 The incentive myth
The next myth that increasingly flourished in this gung-ho environment was the labelling of variable pay, “incentive pay”. Another misnomer, although “inventive pay” may have been nearer the mark. The word “incentivise” seems to have landed around 1990. Since then it usage has soared by 1,400 per cent. A Lexis Nexis search of newspapers’ use of the word “incentivise” revealed a similar trend. Kressler is also very sceptical. “Incentive systems do not motivate because they cannot. Instead they do other things, such as encourage certain levels of performance (I would say only ‘behaviours’ - BJD) independent of the degree of motivation in the short term.” He argues persuasively that motivation and incentive cannot be lumped together. But of course most reward managers and remcos seem to do just that. In short, he plays out the powerful argument started by Herzberg that money does not (of itself) motivate although Gellerman implied it could steer behaviour if paid in very large dollops. His idea certainly seemed to find favour with bankers in the run up to the GFC, with the now known disastrous results.
4.4 The market myth
Kressler insightfully referred to this as the “market-performance paradox”. In all my years of surveying executive remuneration around the world I virtually never encountered a situation where “variable bonuses” went down. Variability was only upwards, with one exception, which was the Ford Motor Company, whose bonuses could go down in a year when sales’ targets were missed.
The logic behind this upwards variable bonus mentality has now been stitched into the so-called market argument: i.e. we must pay the market rate. The original “entrepreneurial argument about some reward being at risk” has atrophied. It has been replaced by logic riddled with self-interest and not a little hypocrisy. This was illustrated by CEOs of banks such as Varley and Hester when challenged about the rates of pay they were offering to new recruits in the midst of the GFC. They fronted with the brazen logic: “We must pay the market rate”- even though most measurements were statistically spurious. No mention even of performance! No pretence of some reward being at risk to foster entrepreneurial behaviour with a focus on results! No mention of creating wealth for shareholders although given the large part of the packages geared to share denominations the risk was a new spin on the old “2-up” gamble: “Heads I win, tails you lose.”
The market-performance paradox has come to this for these CEOs: “If I don’t offer the bonus my recruit will be behind the market.” The market rules. That is one valid factor but should not be the sole determinant, which is further undermining equitable reward since these same CEOs don’t seem to know how to measure the market. The ‘bonus’ is no longer seen as something ‘at risk’, or something that depends on top performance. It has degenerated into an expectation, which is not what the logic of those advocating “entrepreneurial reward policies” had in mind. Worse than that if the bonus is not paid for performance it has to be paid now for spurious ‘market reasons’, “Otherwise I am underpaid!”. How the wheel has turned.
So, by the end of the 20th century, the favoured pattern and stated logic for reward that emerged was:
I have already highlighted in 3.5 the lack of professionalism and inability to measure the market validly and reliably, especially in financial services where it is difficult to find any objective justification for the current pay levels. Now there is almost a defiance that sees little point to even bother measuring the market. Where is the control? The Regulator seems to be a non-felt presence in this field. I was once replacing a job grading system, implementing levels of accountability in a bank that was told by the Regulator “You must have a job evaluation scheme.” The Regulator seemed to be oblivious to the over-layering and ineffective leadership development these schemes were causing in the industry. I was reminded of the Dutch proverb: in the land of the blind the one-eyed man is king.
One also worries that the CIPD seems to have no influence either on this sorry state of affairs. And yet, as I understand it, the CIPD is believed to be the guardian of professionalism and custodian of best practice and standards in the realm of reward management and general HR.
In theory that leaves the shareholders who also seem to have become an increasingly soft touch. The problem is the shareholders are rarely entrepreneurs these days. They are invariably another layer of professional management. Thus, shareholders have become paper tigers. For example, as I write this the Investors arm of the Aviva Insurance company are lobbying other investors to break out Openreach from its mothership, BT. These are managers simply responsible for handling a pile of other people’s funds available for investment. They have no skin in the game and are not noticeably motivated by what is best for BT, its customers, its employees or its pensioners, let alone the health of Openreach. They are simply trying to up the return on Aviva’s investments, which if positive will do no harm to the Aviva managers’ bonuses.
4.6 Governance issues and Remuneration Committees
Robert Maxwell’s pillaging of Mirror Group pension funds in 1988 gave rise to a number of committees and reports on governance. Cadbury in 1992 which “begat Greenbury s (1995) unhappy and unsuccessful attempt to tackle the then heated argument on executive directors’ pay which in turn begat the Hampel Report (1998).” Garratt was rightly critical of Greenbury since it was made up of Chairmen and CEOs of boards whose unhelpful “conclusions” could have been written up in advance. Although these committees generally led to much needed improved governance overall, their contributions to executive reward have simply stoked the fires of greed or at best cognitive dissonance.
4.7 The influence of pay consultants
Remco executives might defend themselves by claiming they are advised by pay consultants who, after all “are the experts in this field” and of course using 3rd party advisors, “guarantees objectivity”.
Reviewing the collective performance of reward consultants over the last 30 years reveals some basic flaws in their various approaches. As I conducted surveys around the world it was noticeable that their interpretation of their own job evaluation systems was applied inconsistently from country to country and even from industry to industry within a country by different consultants. Again, an example from the UK: not so long ago I assessed two key jobs in two different organizations. One in a bank and the other in one of the UK’s largest local authorities. Both jobs were given the same points by the same consultant company. The trouble was one role was at the 4th Level of accountability (in the bank) and the other was Level 6 based on their discrete decision rights. Although consultants vigorously deny this, it was further proof that their systems are driven by their sizing factors that do not truly assess decision making accountability. Banks wallow in other people’s cash which is given to them, local authorities do not.
So, pity the remcos. We now have a situation in which most do not seem to know how to reliably measure the market being advised by consultants who are muddying the water. But, you might say, isn’t this all really irrelevant as the financial services sector is simply awash with greed and this will nullify any attempts to establish fair reward?
4.8 Cognitive Dissonance or greed?
There is no doubt there are people in banking and elsewhere whose god is mammon and who are nauseatingly obsessed with money. It also helps explain the industry’s great resistance to properly splitting retail banking from the casino investment banks. But it would be simplistic to ascribe all these distortions including the explosion of differentials, to greed and moral or ethical deficiencies.
The calculations in both cases assumed a married man with two children (one under 11 and one over 16) and no other sources of income and no other deductions other than National Insurance and a contribution to the company pension fund.