2006 – A case for paying chief executives
Suppose you are told with another
person you have never met or are ever likely to
meet that the two of you are going to share in
a £100 pay out.
The other person has the power
to apportion the award how they see fit. She is
told as you are, however, that if you refuse your
share neither of you will receive anything.
In the past when researchers
have run this experiment – called the ultimatum
game - most people responsible for apportioning
the award decide that the person sharing with
them should get either £40 or £50.
Sometimes they offer the lion’s share as
an added inducement.
When a smaller share, say £10,
is apportioned it tends to be refused, leaving
neither participant with anything.
Refusal of any amount makes little
sense when the alternative is to receive nothing
at all. But such is the psychological need to
feel a sense of equity that most people would
rather go without than allow someone who they
have never met to profit to a much greater degree
than they do, even when the money they would receive
has not been earned.
Not only do most people possess
a fierce sense of fairness, writes, PricewaterhouseCoopers
pay consultant Sandy Pepper in a new book*, the
experiment tends to be influenced by their culture.
In the US, he writes, smaller amounts are more
frequently offered and more frequently accepted.
The Japanese, on the other hand, tend to split
the figure down the middle.
I tried the experiment on my
wife and my middle son separately, suggesting
a figure of £10. My wife said there was
no way she was accepting £10 in the knowledge
that someone else would be getting £90.
My 19-year-old son, however, accepted the £10.
“It’s £10 I didn’t have
a minute ago and I don’t know the other
person,” he said.
His reasoned response is not
typical since most people, like my wife, hate
to think that someone has taken advantage of their
willingness to accept such a small share of the
payout. Denying the offer is to exercise the only
power they have: the power to get even. Getting
even and being even in this case amount to the
same thing. That the levels of wealth at which
both participants will remain are lower than those
that they would have enjoyed appears to be a sacrifice
worth paying for the sake of equity.
That seems to be the case among
PWC partners when Mr Pepper has introduced them
to the game. Most tend to adopt my wife’s
attitude. “I think that what drives PWC
partners more than anything else is a sense of
fairness and I think that this applies to other
well paid people who tend to compare their earnings
with those in competitor companies of a similar
size,” he says.
“I run a course within
PWC and whenever we play this game it provokes
a fierce debate. People get terribly agitated
Logic has rarely played a dominant
role in the accumulation of wealth. Neither has
equity in earnings, although the best efforts
of pay consultants such as Mr Pepper are focused
on ensuring that executive pay is apportioned
relative to an individual’s contribution
to the company.
In a book that he says is trying
to bridge the gap between the approach of pay
practitioners who fix the levels of executive
pay and the economics-based theories of academics,
he tries to address some of the more puzzling
questions surrounding executive pay, such as why
it increased so much in the 1990s and why executive
pay levels in the US soared beyond those in the
rest of Europe.
Specifically he believes such
issues, particularly those exploring the psychological
motivations of executives, need to be understood
by the board remuneration committees of public
companies that since 2003 in the UK have had the
responsibility of setting the reward packages
of executive directors and chairmen.
A broad understanding of ideas
such as agency theory, game theory and tournament
models is useful, he believes, if businesses are
to understand the contextual and cultural features
that influence the way senior executives relate
to their reward packages.
One of the less attractive influences
in recent years has been the impact of what he
identifies as the “winner takes all”
philosophy that has entered the marketplace as
some recruiters reason, like football mangers,
that they will need to pay higher wages than their
competitors to attract the best players.
When this kind of thinking begins
to take hold across the business sector it can
lead to escalating pay increases that run away
from the kind of index-related thinking that governs
broader pay awards. Another long-standing problem
has been the role of pay data guides and sector
comparisons that apportion pay packages in to
quartiles. Few companies want to pay their best
people at rates in the lower quartiles. The result
is a flight to the middle and upper quartiles
that creates a continuous ratcheting upwards of
One of the biggest problems of
fixing chief executive pay, says Mr Pepper, is
that it is not determined by conventional market
forces since at any one time only a few top jobs
may be open, and only a limited number of suitable
candidates may be available.
The result is that top executives
tend to look among their contemporaries when making
pay comparisons. This can prove particularly unsettling
for those running large European companies who
compare their packages with the much more lucrative
deals arranged for their counterparts in the US.
Mr Pepper believes one answer
may be for companies to look more at their internal
pay arrangements to seek what he calls “internal
pay equity”. This is the path chosen by
Du Pont, the US chemical company, that sets the
pay of its chief executive at a premium of 50
per cent over and above the total average rewards
of its divisional directors.
Pay levels of the divisional
directors can be more easily compared in what
is a more effective external job market. “The
idea is to look at the highest level of job where
a real market exists in pay to find a logical
relationship between the reward of the chief executive
and that of the others,” he says. One way
to achieve that relationship, he argues, is to
apply “tournament theory”, an economic
model that assumes executive pay should relate
to promotion prospects as executives move up the
corporate hierarchy. Differentials are lower where
promotion prospects are good and higher in the
more rarefied positions.
One problem with the Du Pont
approach, he concedes, is that it has not been
applied elsewhere and, if adopted in the UK would
lead in most cases to chief executives taking
“It appeals to me because
there is an internal logic about the arrangement
but I’m cautious about the suggestion because
it would mean a fall in executive pay and therefore
it’s hard to see at this stage how that
would be realised. It would need a strong minded
CEO with a particular moral view of the world.”
*Senior Executive Reward, Key Models and
Practices, by Sandy Pepper is published by Gower
Publishing, price £49.