We frequently hear how much more the pay of top executives is rising relative to that of their employees such that income inequality is growing ever greater in our society (here's an example). This is normally justified by saying that these things are determined by a free market, you have to pay a lot to get the best people and good people who create wealth deserve to be properly rewarded. Therefore it was a delight to read a short paper written by Philippe Jacquart and J. Scott Armstrong entitled, Are Top Executives Paid Enough? An Evidence-Based Review. I would recommend it to everyone who has an interest in this subject. Here's their summary of the evidence:
Our review of the evidence found that the notion that higher pay leads to the selection of better executives is undermined by the poor recruiting methods. Moreover, higher pay fails to promote better performance. Instead, it undermines the intrinsic motivation of executives, inhibits their learning, leads them to ignore other stakeholders, and discourages them from considering the long-term effects of their decisions on stakeholders. Relating incentive payments to executives' actions in an effective manner is not possible. Incentives also encourage unethical behaviour. Organisations would benefit from using validated methods to hire top executives, reducing compensation, eliminating incentive plans, and strengthening stockholder governance related to the hiring and compensation of executives.
These conclusions are based on 33 academic studies.
One of the problems with recruitment is that companies rely on the expert advice of recruitment consultants. The problem with this seems to be twofold. Firstly, the fact that decades of research have found that 'beyond a basic minimum, expertise has no value for forecasting outcomes in complex, uncertain situations'. Secondly, because human beings, even expert ones, have a bias towards attractive looking men and against women and the overweight. This is the case even though 'intelligence is the single best predictor of job performance.'
Another factor that undermines the notion that high pay leads to high performance is that CEOs seem to be rewarded for things outside their control. For example, if the price of oil goes up on world markets, CEOs of oil companies are rewarded. Essentially top executives get the credit and the rewards for being lucky, while employees do not.
Linking financial rewards to improved performance seems to be counterproductive. One reason for this seems to be that the prospect of getting a bonus takes up too much attention leaving less to concentrate on doing the actual job. Also, the creation of financial incentives appears to have unintended consequences. They make executives pursue more short term strategies to inflate their companies' share price rather than seeking to insure the long-term profitability and sustainability of their businesses. Sadly, it can to lead to unethical behaviour, lying and outright fraud:
'Incentive plans are likely to tempt executives to engage in fraudulent behavior. For example, school superintendents in Philadelphia were asked to improve their students' standardized test scores. Some superintendents were highly successful and were sought after by other schools. However, the key factor to their success was that they put a program in place to erase wrong answers on student exams and insert correct answers.'
The paper goes on to describe the Mondragon Cooperative Corporation based in Spain's Basque region. It has a very democratic structure where employees elect managers and the ratio of compensation of the highest paid to the lowest is capped, currently at 11:1. Yet between 1996 and 2008, its sales increased by more than 213% while sales at its Spanish rivals increased by only 140%. This reminded me of Waitrose and John Lewis in the UK, firms that do very well with their partnership structure. Indeed, in every Which survey that I have ever seen they beat their more 'commercial' rivals for customer satisfaction.
The authors make a number of suggestions for improving executive recruitment and performance. Two struck me in particular. The first was that recruiters should not meet candidates until they had decided to make them a job offer. This would make them rely more on objective measures of intelligence and avoid the kind of bias mentioned earlier. The second, which resonated because it is so market-based and therefore the kind of thing that should appeal to any budding red in tooth and claw capitalist, is to make applicants for top executive jobs submit sealed bids, setting out how much they were prepared to do the job for. Now this would be an initiative I would love to see trialled.
PS Here is another interesting post on this issue from Simon Wren-Lewis
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