corporate strategy

The worst kind of problem you can ever face in any business is easily described. It’s chronic, it’s significant in effect, it’s costly, and it’s insoluble. The first obvious conclusion is that somebody inside the organisation doesn’t want the problem to go away. Rather, there are powerful vested interests that benefit from the disease.

The cure might contribute greatly to the corporate health, but the pirates who gain from the sickness are not truly interested or impressed by that. To quote the title of a famous British screen comedy, the motto of the beneficiaries is ‘I’m All Right, Jack’.

The title referred to the then notorious selfishness of the British trade unions. So long as their pay demands were met, they had little or no concern for the wellbeing of the company. In the current context, Jack is a highly appropriate name. Jack Welch in his two decades as CEO of General Electric built a billion-dollar personal fortune from a high salary, pension contributions, bonuses, and various capital incentives - mostly stock options. And this was probably the most highly admired executive in America.

The admiration was somewhat muted by the unhappy revelation, after the hero retired and suffered a bitter divorce, of massive fringe benefits that were plainly indefensible. Welch’s high reputation and visibility intensified the criticism, but there’s no reason to suppose that other business leaders (including some of much lesser importance) have failed to dip their paws into the same troughful of perks. And that, remember, is on top of financial ‘compensation’ and ‘incentives’ that always add up to colossal sums.

COMPENSATION AND INCENTIVES

The terms in the previous sentence have been put in quotes to emphasise their peculiarity. ‘Compensation’ in its general use means making amends for some loss - in this case, presumably that of the executive’s time.

‘Incentive’ suggests that without the payments under scrutiny the executive would not make the maximum effort to enrich the employing business. There’s some reality here. Some top managers are in truth paid just for coming to the office, and their colossal payments pile up without any link to recognisable achievements.

How colossal is colossal? One measure is to compare top executive receipts with the pay doled out to lesser employees. In the year 2000, according to Fortune, the reward for the top three executives of the biggest companies soared to the once unimaginable height of 785 times the average worker’s pay. Since then stock options have been less stupendously productive. In 2004 the multiple sank back to a mere 350 times. To set that in perspective, however, view it against the 54 times ratio of 1936.

That 1936 ratio is still far ahead of 25% - the number thought fair by the magisterial Peter Drucker. He was no doubt influenced by his deep knowledge of the Japanese economy, where executive greed is not allowed to run rampant. The same used to be true, however, of the European economies. Not now: Fortune lists 25 Euro-bosses (starting with L’Oréal’s Lindsay Owen-Jones and ending with Harry Roels of Germany’s RWE) whose income runs the gamut from $32 million to $4.5 million.

Note that Roels is not quite so poor as that $4.5 million might suggest. He also pocketed $12 million in long-term incentives. All the devices that American compensation consultants have devised have migrated to Europe; that is partly because the very same consultants have been highly influential in this market. Their firms are the stern guardians of the Holy Grail of executive reward: Comparability.

Executives, too, worship at the shrine. The level of Owen-Jones’s pay was no doubt influenced by the remuneration enjoyed by his American cosmetic competitors. Since one of the latter, Ronald S. Lauder, is rich enough to have paid, without blinking, a world record $135 million for a painting by Gustav Klimt, his industry rivals have a great deal of headroom when it comes to fixing their own earnings. But can you really compare a family foundation like Estée Lauder with a typical corporation?

For that matter, can you compare European incomes with the much higher levels long enjoyed by US businesses? Of course, you can’t; but of course you still do it - the argument goes that Owen-Jones would have scurried off to higher pay across the Atlantic if he had not won suitable reward from his French owners.

The chief fault with this much-used postulate is that there is precious little evidence of any such transatlantic managerial brain drain. At this level of seniority, there is too much to lose – and not enough to gain - by going West.

DO INCENTIVES WORK?

However, American managers going eastward (more numerous, but not greatly so) can and do demand levels of remuneration that make their transfer exceedingly worthwhile. The value has often been to the traveller rather than his or her new employer. This is not surprising, since much of the transfer package may be paid upfront. It’s a very odd incentive that gets paid for work that hasn’t even begun, let alone brought success. But incentives are curious, anyway. For a start, do they actually work? Does incentive pay have any effect, and if so, what? A few years ago, I reported puzzling findings by motivation consultant John Fisher. He noted that numerous studies over the years in the US had found virtually no correlation between increasing pay and corporate performance. As for Britain, ‘a study by management academics drawn from three universities looked at the FTSE 350 companies to see whether long-term incentive plans did affect performance - and came up with an astonishing result.

‘These LTIPs rewarded directors with free shares if they hit specified targets for total return to shareholders (in which the share price is by far the largest component). Companies whose bosses luxuriated in LTIPs increased shareholder returns by 20.71% over the period in question. As for those without LTIPs, the result was 20.74%. In other words, the schemes, costly to administer and a bureaucrat’s delight, made not a scintilla of difference’.

THE REWARDS GAP

There’s one obvious difference that I might have mentioned, though. The incentivised managers ended up considerably richer than the others by achieving exactly the same performance. Eventually the under-privileged will catch on. ‘Those top managers without LTIPs or similar rich gifts will no doubt join the party sooner or later, and they, too, will begin to waste their time (from the shareholders’ viewpoint) on working out ways to enrich themselves and each other’.

The study mentioned above, by the way, didn’t test the targets used to set the levels at which incentives kick in. No chief executive in a major business will accept a target that he considers unreasonable. A reasonable target, however, is one that is eminently likely to be hit - one that, in other words, does not demand exceptional performance from senior managers. On close examination, the rewards are the only items which are exceptional (apart, that is, from their almost universal adoption).

It’s hard to avoid the conclusion that every device and every decision taken in the realm of executive pay has but one purpose: to enrich recipients as much and as often as possible.

All the arguments put forward to justify these efforts are so much hogwash. There is only one excuse for these excesses. It’s weak, but at least it’s valid. Nobody has any idea of what criteria would produce a more equitable and effective result.

But even if some deep thinker came up with a plan, who would be interested? Who has serious concerns?

Politicians should theoretically be concerned by the sight of very fat cats getting even fatter at the unhappy shareholders’ expense. Fortune has duly found one anxious politico who believes that ‘If the rewards of capitalism become extraordinarily high with no link to performance, it undermines confidence in capitalism’.

The provenance here is none too good, however. The source is Jeb Bush, Governor of Florida. It’s a safe bet that neither he nor his Presidential brother will take any action against the financial interests of the fat cats - who, naturally, include themselves.

Anyway, the Bush hypocrisy is devoid of any useful meaning. Good intentions are more evident in this quote: ‘The CEO has a duty to be an exemplar for the civilisation. Why take everything, just because you can?’. The speaker here, though, is Charlie Munger, the right-hand man in Warren Buffett’s fantastic build-up to a $44 billion fortune. Not a few of the Buffett billions have been reflected in Munger’s own great riches. Once again, Jack is all right, which puts him in no position to moralise.

INDIGNANT WRITERS

The most indignant response to the scandals comes from the scandal-mongers: journalists. Looking at options, a Fortune writer, under the headline ‘Options Gone Wild!’, tries ‘separating the flagrantly illegal from the merely slimy’: activities like ‘forward-dating’, ‘spring loading’ and ‘bullet-dodging’ sound slimy, but ‘it’s unclear they’ve violated the law, no matter how unseemly the practices may appear’. And that’s despite the supposed tightening of legal controls in the wake of the Enron and WorldCom horrors.

The problem goes back to the days of ancient Rome, and no doubt further; ‘Quis custodiet ipsos custodes?’ Who is going to guard the guards? In theory, the funds are guarded by the outside directors, but 75% of the latter, when questioned by Pricewaterhouse Coopers under a year ago, agreed with the flat statement that ‘US company boards are having trouble controlling the size of CEO compensation’. The outsider guardians, in other words, come under pressure from the insider pirates, who are the biggest hypocrites of all.

Amazingly, Treasury Secretary Henry Paulson derived his ‘agenda for change’ in these matters from three top executives, respectively heading the Business Roundtable, the New York Stock Exchange and the Financial Services Forum. All three unworthies have since been ousted for not-so-little matters like ‘huge accounting errors’, ‘an egregious lack of disclosure’ and earning $22 million at the end of a five-year decline in the stock price. The latter boss, by the way, collected $43 million in severance pay. Come rain or shine, the dinner pail stays full.

In a sensible organisation, the principles for paying senior people would have a clear, strong base. Their reward would have the same rationale as rewards for all other employees. The only difference would be size, since plainly fairness demands that rewards should rise with responsibility, seniority and contribution. The code would have these elements:

• Give employees access to details of all reward arrangements for all colleagues - including fringe benefits and perks.

• Fix base salaries that are competitive, but not excessive, at all levels.

• Include every employee in a cash bonus scheme with three components (a) payments related to company performance (b) payments related to unit results (c) payments related to individual performance.

• Apply the same percentages to all employees in determining bonus payments.

• Devise long-term incentive schemes giving all employees a meaningful stake in the business.

• Use the same principles of transparency and equity for pension arrangements.

HEALTHY AND WEALTHY

Another basic principle is that the sum total of all these payments must leave a very healthy and wealthy share for the owners of the business. Fortune rightly argues that the shareholder should come first. No payments other than base salary and pension should be made unless the organisation is covering its cost of capital, including equity as well as debt. The cost of equity belongs to investors, and they should explicitly receive that cost as a return on their investment.

That last paragraph should ring a bell. It’s the same concept as that used in calculating EVA, or Economic Value Added. The EVA addict works out the cost of capital (including equity) as above, and compares it to the number for operating profits after tax. Unless there’s a handsome surplus, management hasn’t been doing its duty and doesn’t deserve any bonus or other extras. You could even argue that they don’t deserve a base salary, either, since they are actually devouring the company’s and the investors’ capital.

An added advantage of the suggested regime is that the non-executives and the outside investors will have a clear idea of the reward system and how it relates to genuine achievement. My bet is that the atmosphere and shared commitment in the business would also be invigorated. The trouble with the present order isn’t only that it’s greedy and crude. Worse still, it doesn’t deliver the goods - except to the greedy pirates.