Economy//

How the bonus culture is holding UK businesses back

Written by: Luke Hildyard on 23 January, 2013
Filed under Economy

The debate around high pay is characterised by emotional language. Terms like ‘fat cats’, ‘eye-watering bonuses’ and ‘politics of envy’ are abound. Sometimes that’s understandable.  When reading, for example, of the £25 million bonus pot shared by eight RBS executives last year, while 30,000 ordinary employees were subjected to a pay freeze (not long after a further 29,000 had been made redundant), raw anger felt like a more appropriate response than a dry critique of the bank’s behavior based on the business case.

So it’s important not to take the moral dimension out of the high pay debate.  But the policy problem is a matter of more than just fairness and perceptions of fairness. The economic impact of outsized and poorly-structured executive pay packages is significant.

The High Pay Centre’s recent research on performance-related pay highlights how the current bonus system and so-called ‘Long-Term’ Incentive Plans (LTIP) reflect the flawed objectives of many UK businesses. LTIP’s are overwhelmingly linked to the company’s share price, usually over a period of three years, and to the rate of earnings per share, calculated by dividing the net profit by the number of available shares.

Assessing executive performance on the basis of how much money they are making for shareholders appears sensible on the surface. But these headline financial indicators can often be opaque, or even misleading, in terms of what they reveal about the long-term health or strategic direction of the company.

Writing in the Harvard Business Review, Rosabeth Moss Kanter states that “the value that a company creates should be measured not just in short-term profits or paychecks, but in how it sustains the conditions that enable it to flourish over time”. This could refer to critical performance areas such as employee engagement, customer satisfaction, social responsibility or brand and public reputation.

These factors are not necessarily reflected in share price or profit measurements, which record what was achieved, but not how it was achieved.  Building a business in the way Kanter suggests often conflicts with the incentives to deliver three-year profit/share price increases in executive performance-related pay packages. So the huge bonuses awarded to executives for meeting performance targets are not only socially divisive, they encourage bad business practices.

For example, companies can cut employee numbers or freeze their wages, take steps to limit the amount of tax they pay, avoid replacing outdated equipment or cut R&D budgets in favour of buying their own stock to manipulate the price upwards.  In the short-term this improves financial performance, but damages the company’s internal capacity, as well as its standing in the eyes of key stakeholders including employees, customers, and the general public.

BP’s cost-cutting on safety procedures prior to the Deepwater Horizon disaster (ultimately costing them $100 billion) are an example of how badly this can go wrong. The recent Tesco horsemeat scandal also suggests negligence in relation to product quality and customer service.  Former industrial giants, GEC and ICI now no longer exist, after focusing their efforts on investments and acquisition in the 1990′s, rather than developing a successful core business model.

This is disastrous for those individual companies, of course, but also has an impact on the wider economy.  Returns generated by ‘value extraction’ (e.g. holding down wages, minimizing tax bills) rather than ‘value creation’ (developing a great product or brand) do little to increase growth. If corporations withhold money from workers or government, this hinders the spending necessary to kick-start an economic recovery.

US academic Lynn Stout also notes that the UK is relatively unique in its obsession with generating shareholder value, and claims that our obsession with short-term share price and profitability mean that the UK has far developed fewer leading companies than our international competitors, and the ones we do have are overwhelmingly concentrated in finance and commodities extraction. Certainly there are more French, German and Japanese companies amongst the Fortune Global 500 list of the world’s biggest firms. These countries also invest a higher proportion of GDP in R&D than the UK, in part because their leading companies are less in thrall to a culture that demands immediate results for short-term shareholders, meaning they are better-placed to generate innovation-based growth in the future.

Radical reform of executive pay is vital to re-orienting UK businesses towards a longer-term, sustainable business model designed to contribute to inclusive growth. Performance-related pay is difficult to justify at all, given that it is almost uniquely confined to captains of industry – high court judges, generals, politicians and senior civil servants manage to cope on their basic salary (indeed target-based cultures in other sectors have been widely discredited). If it is to continue, it should form a much smaller element of total pay, and a larger component should be directly linked to fundamental non-financial performance measures like employee engagement, customer satisfaction and public reputation. Companies could follow the example of HSBC, in deferring share-based compensation for the duration of the executive’s career, rather than the standard three years. Employee representation on company boards would ensure a wider range of company stakeholder perspectives are reflected in strategic decision-making.

Most of all, though, these measures should be thought of as a response, not just to a moral outrage, but also a major structural economic problem.