The market failure approach to executive pay

Compensation paid to CEOs have risen faster than company earnings across the globe, according to the author of this blog, suggesting that the original hypothesis set out three decades ago to use executive pay to drive financial performance hasn’t particularly worked out. Whilst the blog doesn’t offer an alternative, it does dig into what is stopping a better approach to executive pay and hence provides a pathway to get to a better alternative if we could address these impediments. He refers to the inefficiency of the labour market which creates four such impediments:

1. Isomorphism: ‘Isomorphism’ describes a process whereby social practices develop similar forms over time. Remuneration committees copy the pay strategies of other comparable organisations (known as ‘mimetic isomorphism’). Companies are constrained by laws and codes of practice established by government and regulators (‘coercive isomorphism’). They seek advice from remuneration consultants who benchmark pay data and recommend standard solutions (‘normative isomorphism’).      
2. The remuneration committee’s dilemma: Remuneration committees also face a ‘prisoners’ dilemma’ as they seek alternative ways of rationally determining top pay. As a result, they pay over the odds, in the vain hope that they might attract one of the better super-managers and avoid the worst. Offering higher pay becomes the dominant strategy, even though by doing so, companies will generally be no better off than if they all paid more moderate salaries.
3. The investors’ collective action problem: While a £3.25 million bonus paid to the CEO of a FTSE100 company might seem a lot of money, to a large investment management firm with £50 billion of assets under management, holding, say, one per cent of the company’s shares, the amount involved is relatively trivial, especially if the question is about whether the CEO’s bonus is ten or twenty or even thirty per cent higher than it should be. Investors have historically been prepared to accept rent-seeking behaviour by managers as long as their reasonable expectations of dividends and capital gains are met, because they expect the cost of intervention to exceed any individual benefit.
4. LTIP Valuation issue: A further reason why CEO pay in the UK and US has increased so much more rapidly than average earnings is due to the delivery mechanism. If you were to offer an executive £100,000 in cash or a share-based performance-related long-term incentive (an ‘LTIP’) with an economic value of £300,000 don’t be surprised if he or she would prefer to take the cash. By the time they have applied subjective probability-based discounts for uncertainty of around seventeen per cent, and time discounts of thirty three per cent per annum, the subjective value which the executive attaches to the LTIP may be as little as one third of its economic value. A consequence of providing people with an asset they do not fully value is that they want more of it to compensate for their subjective ‘loss’ in comparison with less risky, more certain, and more immediate forms of reward.”

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