Chuka Umunna on executive pay

Chuka Umunna, 12/01/2012

Category: Labour Politics (General)

Chuka Umunna MP, Labour’s Shadow Business Secretary, in a speech to the High Pay Commission and Institute for Public Policy Research, said:

Thank you for that introduction Michael and to the ICAEW for hosting this event.

And thank you too to the High Pay Commission and the Institute of Public Policy Research for inviting me to speak.

All three organisations have made major contributions to informing and stimulating the national debate on this issue which has dominated the news agenda since the year started, the High Pay Commission in particular.

The headlines and clipped news reports do not do justice to this issue so today my aim is:

- to explain why excessive pay and rewards for failure matter from the point of view of our businesses, those who own them and society at large; and,
- to get to the heart of the problem and outline the solutions as we see them in Her Majesty’s Opposition.
 
The economy is the issue of this parliament not simply because of the lack of growth and the highest rate of unemployment for 17 years which people are experiencing in the here and now. But also because of the long term structural trends in an economy which has failed to deliver incomes to keep pace with rising living costs, a pattern repeated in other developed economies.

What do I mean by this? Not enough of the reward from rising productivity has found its way into the wage packets of average earners with the result that middle income earners have actually seen their wages stagnate from 2003, whilst high earners have seen their wages soar. Consequently many people have come to feel that, in the good times the economy did not really work for them, while in the bad times they were being made to carry much of the risk.

So it is time for some hard reflection on the nature and direction of our economy and the changes we need to make:

- changes to get growth going again in the short term, which is why we have put forward an immediate stimulus package in the form of our 5 point plan for growth and jobs;
- changes to ensure that future prosperity benefits everyone;
- changes to ensure we can pay our way in the world and take full advantage of the new opportunities that new markets bring – which is why we need to build a New Economy based on a reformed capitalism.
 
The FT have just started a series of articles under the title Capitalism in Crisis. I wouldn’t go as far as those dangerous lefties. Capitalism has been and remains a powerful engine of human progress. But in recent speeches and, again, over the weekend I argued that what we need is a New Economy based on a better, more responsible and more productive capitalism than our current national variety.

That New Economy must be built on a partnership between productive business and active government: the entrepreneurial impulse in us all encouraged and supported; closed circles broken up and opened to everyone. And, as Ed Miliband said in his speech on Tuesday, we must think how we build a New Economy that delivers fairness for Britain at a time when there is less money to spend.

In many ways, the issues around executive pay are a good place to start. Excessive pay and rewards for failure are symptomatic of what is wrong with the way our economy has been operating over the last 30 years – of how wealth is created, how opportunities are shared, how success is rewarded, and how power is exercised in our companies. It is something Ed Miliband has been talking about for many, many months now.

There are some who say it is no business of government - no business of politicians - to be commenting on these matters. We have no right to interfere in the affairs of privately owned companies is their refrain. I could not disagree more strongly with that statement.

At the heart of my politics is the belief that we are all mutually dependent. This notion is deeply embedded in the values of the Labour Party. Better together. Stronger together.

So to argue that politicians and society at large, should not take an interest in these matters, is to feed the idea that society is here and business is over in the corner there which is dangerous.

Why? Because business and society are not separate islands - they are mutually dependent. Business needs a strong society, providing it with human resource, talent and custom. A strong society needs everything that productive business can offer: the jobs, the growth, the innovation, the opportunities, the wealth creating potential. That is why we should take an interest in the pay issue.

And while it is right that those who work hard, generate wealth and create jobs for our country are rewarded, where failure is rewarded or people award themselves huge pay rises that bear no relation to performance or what their companies can bear, trust is severely undermined. As Ken Costa, the former Chair of Lazard International said last October:

“Put bluntly, ultimately businesses cannot work, banks cannot lend, economies cannot function and societies cannot flourish without mutual trust and respect, or without fundamental honesty and integrity.”

That is why the contributions that the ICEAW have made are so welcome - you are the important keepers of the accountancy flame, your mission to ensure that “people can do business with confidence”. And here you are helping to ensure that people can have confidence in business. That has to be right.

As Sir Roger Carr, the current Chair of the CBI, said on taking up his post last year, business needs to show that it is “a force for good.” This is why it was so ridiculous for the Prime Minister and others to infer or suggest that Ed Miliband was being anti-business for raising these issues in his Labour Party conference speech last year – it is very much in the interests of business to resolve these problems and it is rather ironic that the PM is now talking about the need for reform in much the same terms as Ed.

The discussion should start by asking what we pay people for? We pay people to do a job and, where they do so successfully, people do not object to them enjoying the fruits of their success. As for bonuses – my colleague the former Chancellor Alistair Darling put it well last Sunday when he said a bonus is surely “something special, something unusual, something that you give for that little bit extra, not a matter of routine and entitlement.”

Having a skill that is in short supply but high demand is likely to be well rewarded in the marketplace. And as the size of some markets has increased – to become continental and in some cases genuinely global – so have rewards to those at the top have risen.

Of course it is not easy to chart a successful course for a major corporation, where the contours of the market place can change rapidly, where new competitors are around every corner, and where new technologies can make an entire business model obsolete overnight. It takes special skill and extraordinary commitment. So no one is against success that rewards this merit and application. Success should be rewarded.

But increasingly, what we have seen is something else. Reward that is not linked to success or performance: a self-perpetuating spiral of remuneration for those in the golden circle. Handsome rewards for failure. Rewards that seem quite unbelievable to the vast majority of people in this country; rewards from another planet.

And while there are more egregious examples that have gained notoriety, this is not about individuals. The growing gap between increases in pay and increases in company performance is systemic. In the last decade the value of FTSE 350 companies increased by eight per cent, while the average total earning of executives in those companies increased by one hundred and eight per cent.

As rewards at the top have become disproportionate to company performance, so rewards for executives have become disconnected from the rest of the workforce. They are no longer just the best paid employees. Increasingly, they are becoming a class apart.

And let us be absolutely clear who we are talking about – we are not talking about the budding entrepreneur, the small business owner struggling in tough times; this does not apply across all business. We are talking about the relatively small number of people running our largest businesses and working in our more prominent financial institutions. We are talking about FTSE 100 bosses who were paid 14 times the median pay of a worker in 1980, and who are now paid 75 times the median pay of a worker.

I should also point out that this is not a recent phenomenon, but a trend over the last three decades. In the three decades to 1979, executive pay grew 0.8% on average. In the last ten years, growth in the pay of FTSE 100 executives has been closer to 20% a year. It has now reached a point where, as Richard Lambert, former Director General of the CBI said last November, it is “damaging the interests of British business in political, economic and reputational terms”.

Why is this ballooning pay such a problem? For three reasons: it is a bad for the companies themselves; it is bad for our economy overall; and, yes, it is bad for our society.

For the companies themselves, the issue is a classic problem of agency.
Since the 1980s there was a move to create an entrepreneurial culture amongst executives at the top of our large corporations but it didn’t quite work. I’ll explain why.

The owners of the company – the shareholders – entrust executives with substantial powers to make far reaching decisions about the running of the company. Oversight is difficult, because those involved in the day to day management have plenty of discretion and a large information advantage. How can shareholders ensure their agents, the directors – the executive directors in particular - act consistently in those shareholders best interests? The solution was to try to align the incentives – through bonuses, shares, share options, incentive plans and the like, using different mechanisms and over different time frames.

But the fact is that it is hard to create a true entrepreneurial culture among executives at the top of a large corporation. Upside incentives can be made similar, but the structure of downside risk is completely different for an entrepreneur who has everything on the line. Entrepreneurs have most of their own money on the line when they make decisions; executive directors of large companies do not.

The result has been that the value of incentive packages for executives has risen out of all proportion to improvements in company performance. If it ever worked, it seems that there are now declining returns. In the first decade of this century FTSE 350 firms increased their pre-tax profits by 50% and their earnings per share by 73%, while year end share prices fell by 5%. Over the same period, bonuses for executives in these companies have risen by 187%, long term incentive plans by 254%. This demonstrates what psychologists have already found – that the relationship between financial incentives and performance is far from simple, and is not even reliably positive.

At the same time, the heavy focus on the alignment of high powered incentives risks crowding out other, more rounded but equally powerful intrinsic motivations of executives that are just as relevant to the company’s success – the satisfaction of doing a good job, the pride in leading and growing a great company, of winning in the market place, of having the respect of peers, of creating a legacy of sustained and sustainable success.

We are not opposed to performance related pay but it does make you wonder: if a company is so concerned that an executive paid only their salary won’t be motivated to work hard in the best interests of the company, then maybe they have the wrong person in the job?

At its worst you end up with perverse incentive structures which encourage the wrong kind of decision making, as the failures in many financial institutions in the wake of the 2008/9 financial crash so clearly illustrated.

And this approach to executive reward creates negative consequences in other parts of the business. Overemphasising the importance of the contribution of those of those at the top can undermine the motivations of others in the business. As the High Pay Commission has shown, there is a growing body of research that confirms that just as relative rewards matter as a basis for social comparison among executives, so they matter to other employees too. They matter for employee engagement, and their sense of identification with company goals. Feelings of unfairness in pay reduce the willingness to cooperate, can reduce effort and weaken commitment. Unsurprisingly, greater pay inequality in a firm has been found to be associated with lower firm performance.

So excessive pay and rewards for failure are undoubtedly bad for business.

The second reason this is a problem is because it is bad for our economy. I’ve lost count of the number of companies I’ve visited who say to me that they can’t find the engineering graduates they need to hire. Where are they? Lets face it - many of them are following the money. In the decade to 2007, 60% of the increase in the income share of the top 10 per cent went to finance workers. This talent drain, with rewards disproportionate to success, has distorted the market and makes the challenge of rebalancing the economy – by region as well as by sector – so much harder.

Likewise, entrepreneurs, those running our small businesses are the lifeblood of our economy, providing approximately two thirds of private sector jobs and almost half of private sector turnover. We need people to take risks and set up these businesses - why would they do so if they can earn excessive wealth in the boardroom and the City?

And the third reason this matters is because it is bad for our society. Executive pay has helped promote inequality and there is a huge body of research to show that this has a detrimental impact on society. At this juncture many people refer to the “Spirit Level”, the book by Richard Wilkinson and Kate Pickett.

Today, I’ll refer you to comments of the former Chief Economist at the IMF, Raghuram Rajan – the IMF is of course George Osborne’s institution of choice when it comes to quoting people! He has argued that high levels of inequality contributed to the financial crisis. In his recent book, Fault Lines, Rajan explains how high levels of wage inflation at the top and wage stagnation for the rest of the population led to a growth in easy credit.

So I have talked about what we pay people for, how a small group are being paid far in excess of what they deserve, and the adverse impact this is having on our businesses, our economy and our society. What would we - the Opposition - do to change all this?

The High Pay Commission has put forward a tranche of recommendations to increase transparency, accountability and fairness. The recommendations enjoy support in the business community and are in line with measures implemented in the U.S., Germany and other countries to address these issues. We support them too.

In the main, the Commission suggests seeking to effect the changes through the UK Corporate Governance Code in the first instance, followed by legislation if the amendments to the Code do not bring about the change needed. This is the right approach. Legislation should be the last resort, used only if there is not sufficient compliance with the Code within a reasonable period of time.
On the proposals themselves: first, transparency – over the level of reward and over the approval of reward packages. In trying to align executive incentives, reward packages have become increasingly complex, making it difficult for shareholders to understand exactly what is being paid.

This problem is intensifying. Increasing numbers of directors are being rewarded through ever more complex service agreements. Individual reward packages are more generous and ‘performance’ targets seem to be getting easier to hit.

To enhance transparency, the High Pay Commission recommends that:

• Executive pay should comprise a basic salary, with only one additional performance related element where necessary;
• The publication of pay packages of the ten highest paid employees outside the boardroom; and,
• The reporting of pay packages in a standardised form, including a single figure showing total remuneration.

We endorse these proposals. They will give shareholders access to simple, standardised information on which they can make reasoned judgements. While we wait and wait for this Conservative led-government to match words with deeds, there is no reason why business cannot begin taking action now.

In addition, the Commission proposes that investment and pension fund managers be required to disclose how they vote on all issues, including on remuneration. This transparency would allow pensioners and investors to see where their monies are being used to finance big pay deals. It is their money, after all.

This increase in transparency would also increase accountability, and is just one of a number of changes needed to do so.

To examine the dynamics of a remuneration committee is to observe a case study of what happens when responsibility is diffused, backgrounds of participants are homogenous, and loyalties can overlap. Participants are drawn mostly from a narrow class of, mostly male, current or former executives. The voice of employees is silent and shareholders vote in an advisory capacity on remuneration reports after the event. You don’t need to be a rocket scientist to detect a problem with this old way of doing business.

The way non-executive directors are appointed and the backgrounds from which they are drawn – they are often ex-executives themselves – is not conducive to the appointment of people who are prepared to shake it up and introduce new ways of thinking. That is why we endorse the Commission’s recommendations to have employee representation on remuneration committees and to open up the recruitment of non-execs to a wider pool.

But I want to look at where we should go further. In the UK, the nomination committee of the Board - which is responsible for hunting out people to serve on boards - is made up of other Board members. Candidates are nominated by those Board members at the company’s AGM and, in most cases, are elected as a matter of course.

We should consider moving towards a system which other countries have adopted where the nomination committee is not composed of board members but is composed of the four or five biggest shareholders in the company along with the non-executive chair of the board – that same committee, composed of shareholders, also recommends the structure and amount of remuneration. This would create far stronger lines of accountability to those who ultimately own the business and would promote the shareholder activism and engagement which is key.

In addition the role of remuneration consultants must be looked at, as the Commission says in its report. In his 2006 letter to Berkshire Hathaway shareholders, Warren Buffet referred to a remuneration consultancy called “Ratchet, Ratchet and Bingo”; “The name may be phony,” he said, “but the action it conveys is not”, highlighting his view that such consultancies inflate executive pay. There are widespread concerns that these consultancies are ratcheting up pay here too.

Indeed, it is my view that, unchecked, their effect could be similar to that of unscrupulous football players’ agents – inflating salaries sometimes way beyond talent or contribution and often working against the long term interests of the companies themselves.

Part of the problem is that – in their advisory role to remuneration committees – the consultants owe their duties to the Board and not to shareholders. This needs to be looked at, along with the risk of conflict where consultants are advising both executive management and non-executive directors on remuneration. That is why it is right that companies should publish the extent of their use of remuneration consultants.

I am aware of the voluntary guidelines to prevent remuneration consultants cross-selling services but, given the risk of conflict, consideration should be given to taking a more strict approach. Lawyers giving legal advice in the same context are not subject to some voluntary code but to binding rules that prevent the provision of advice where there is a potential for conflict of interests, unless strong, viable and properly policed Chinese Walls are erected. Why should the same not apply here?

Finally, on fairness, the disconnection of executive reward from the pay of other employees is at the heart of loss of trust. This needs to be rebuilt. That is why we endorse the Commission’s call for companies to publish the ratios between the highest paid employees and the median.

It is also another reason for having an employee on the remuneration committee of the Board, something the Prime Minister has failed to commit to implement – as Ed said on Tuesday, it would mean top executives would have to look an ordinary member of staff in the eye before they award these pay packages.

To continue to inform this important debate, we endorse the High Pay Commission’s call for a permanent body to monitor high pay, along the lines of the Low Pay Commission Labour established.

All of these measures are designed to empower shareholders – to give them the tools to be able to take action, and to increase the accountability of directors to them.

David Cameron has sought to do this by making shareholder votes on remuneration binding. We will examine this proposal when Vince Cable, my opposite number, provides further detail later this month.

However, there are a number of problems with what he has suggested. First, it is backward looking. As CBI Head John Cridland has said, this would be like shutting the stable door after the horse has bolted.

Secondly, there are large practical difficulties with the proposal as its retrospective impact would create legal problems in trying to unpick contracts already agreed – I say this from my own experience, having practiced as a specialist employment law solicitor for the best part of a decade.

And thirdly, without a matching requirement of transparency – the provision of clear and simple information – shareholders may not be any the wiser about what they are voting on, and may even be less inclined to vote.

So it is not enough for David Cameron to say he wants shareholders to be given a vote on these issues. We have seen and heard this kind of thing from him before - talking a good game but fiddling at the margins.

I believe in shareholders’ democracy but democracy is about more than voting. If we are to empower shareholders, they need information provided through greater transparency of boardroom pay – as well as the means to mobilise and become more active in the running of their companies.

And this takes us to the heart of the issue – the need to encourage greater activism amongst shareholders. We cannot ignore the long term trends that are working against this. Since the early 1990s, foreign ownership of total UK equity has increased from less than 15% to around 40% in 2008. The average length of time investors hold their shares has fallen from 5 years in the 1960s to less than 8 months by 2007, with an enormous increase in high frequency trading.

These trends make it harder, but all is not lost – there are grounds for optimism. Voting by shareholders in FTSE 350 companies has now risen to a respectable 68%. There is clearly an appetite for more shareholder power and we have to nurture the use of it. It can be built upon by putting more – and more effective – tools in the hands of shareholders in the way I have described.

And all this needs to be underpinned by a renewed and explicit focus on relative reward based on merit – the fairness that inspires employee loyalty to a company, and the fairness that renews public trust in business.

The current business environment is as tough as it has ever been. Labour has set out a plan for jobs and growth to get the economy moving again, get people back into work, and to reduce the deficit.

But we also must address the underlying challenges in our economy that have persisted over many years, and which the financial crisis brought in to sharp relief. Excessive executive pay is one of them.

That is why I am glad that this debate is going on and proud of the role that Ed has played in leading it. Let’s make it count. Let us begin preparing the ground for the better days that lie ahead. Let us build a better economy for Britain.

Thank you.