Reforming CEO pay

‘The other side just doesn’t get it’ is a common refrain in Australian policymaking these days. But nowhere is it truer than in the CEO pay debate. One side points to skyrocketing salaries, with the average pay of a top-100 CEO rising from $1 million to $3 million since 1993 (about twice as fast as the pay of other workers). The other side argues that investors put their life savings on the line, and asks why society should prevent shareholders from choosing the remuneration package they want for their managers.

In reforming executive remuneration, it’s important not to forget the role that great managers play in underpinning economic growth. In a classic 2003 article, economists Marianne Bertrand and Antoinette Schoar showed that many of the systematic differences between firms could indeed be traced back to managers. A manager in the top quartile increases the rate of return on assets by about 3 per cent. One in the bottom quartile reduces the rate of return on assets by about 3 per cent. The authors quote former Citigroup CEO John Reed: “In the old days I would have said it was capital, history, the name of the bank. Garbage – it’s about the guy at the top”.

In the early-1980s, there were real concerns that one of the constraints on growth for Australia was the poor quality of managerial talent. You don’t hear the refrain as often these days – partly because we do a better job of training business leaders, but also because our nation has been willing to hire non-Australian CEOs where they’re the best for the job.

Yet aligning pay and performance is critical. People rightly worry when they hear stories about corporate bosses receiving multi-million dollar severance packages and extraordinary perks (my favourite is the Nabisco CEO who sent a corporate jet to pick up his dog from Colorado, describing him as ‘G. Shepherd’ in the manifest). Such excesses send ripples beyond any one firm – affecting the way many people view executives in general.

In this environment, the Government’s executive pay reforms aim to steer a middle way between the twin extremes of doing nothing (as many in the Liberal Party would prefer), or abolishing tax-deductibility of salaries over $1 million (as the Greens Party advocate).

Four elements to the package – which arose from a Productivity Commission report into executive salaries – are the two strikes rule, rules ensuring the independence of remuneration consultants, a ban on closely related parties from voting on a pay package, and rules against hedging incentive remuneration.

The two strikes rule says that if a sizeable minority of shareholders (more than 25 per cent) vote against a remuneration report two years in a row, then that will trigger a motion to spill the board. Of course, majority voting still applies to any spill motion and the reappointment of directors, but the measure provides a check on pay packages that are opposed by a significant share of those who own the firm.

Second, the rules on remuneration consultants require that both the remuneration consultant and the company board formally declare that remuneration recommendations are free from undue influence. Consultants will also have to disclose how much they were paid, and any other ties they have to the company.

Third, bans on closely related parties means that executives and their family members will be prevented from voting on their own pay packages. This reduces both actual bias, and the perception of bias, which is vital to maintain public confidence in corporate Australia.

Fourth, the government is stopping executives from unwinding incentive remuneration by prohibiting them executives from hedging their incentives. Ordinarily, it’s good to see people using futures markets to reduce risk, but in this case, the impact is perverse. For the same reason we don’t let football coaches self-insure by betting on the other side, it’s a bad idea to allow CEOs to hedge incentive pay. 

There will always be individuals who say that they weren’t consulted or that there wasn’t enough time to respond to proposals, but the reality is that Parliamentary Secretary to the Treasurer, David Bradbury has overseen a pretty extensive consultation process, including hundreds of written submissions and a spate of stakeholder meetings.

Economists often worry about the ‘equity-efficiency tradeoff’ – the potential for growth-enhancing policies to increase inequality (and vice-versa). Yet by better aligning pay with performance, we face the best of all possibilities – a reform that can both increase company performance and curtail the worst corporate excesses.