September 2006 – A case for paying chief executives less

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 about it.”

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 top-level pay.

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 pay cuts.

“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.