The Pay and the Crisis

Political, economic and social pressures in Europe mean that the climate in which remuneration decisions are made is likely to be difficult for some time. As such, the job of remuneration/compensation committees and those who advise them is, and will continue to be, more challenging than it has ever been.

WHY PAY IS HIGH ON POLITICAL AGENDAS

The letter from veteran US investor Warren Buffett to the New York Times recently, in which he explained that his tax rate was lower than that of any of the other 20 workers in his office, has had some interesting consequences. President Barack Obama has declared that he will propose higher taxes for millionaires as part of his re-election campaign – a move that is very countercultural in the US. There has been some resistance by the Republicans, but on the whole the proposal has been well received, which indicates a mood change in the US.

In France, we have seen the so-called "billionaires' revolt", in which a group of the country's wealthiest people, including L'Oréal heiress Liliane Bettencourt, signed a petition to pay more tax. And in the UK, Business Secretary Vince Cable used his speech at the Liberal Democrat party conference in September to attack top pay – again, something that might have been deemed too risky in the past. There are other similar manifestations of the changing political mood on pay in other European countries. Spain, for example, is questioning why large pension payments are made to board members of Spanish savings banks when most of those banks are bankrupt.

SHORT-TERM REASONS BEHIND THE MOOD CHANGE

The fiscal deficits across Europe are leading governments to seek ways of raising additional revenue, and increasing top marginal tax rates is one option open to them.

In addition, there is pressure on real incomes in the "squeezed middle" – in many countries, median incomes have stagnated for several years. This is unlikely to change given the clear need for "internal devaluation" in many countries – that is, when exchange rate devaluation is not an option, as in the eurozone, a country's only alternative is to increase its productivity and reduce labour costs in order to remain competitive. Since the eurozone began a decade ago, Greek unit labour costs have risen by 40% more than Germany's, with the equivalent figure for both Italy and Spain being 25%. These countries need a significant internal devaluation if they are to remain competitive against the leading economies in the eurozone, which means that incomes have to fall. The recent demonstrations in Greece suggest that the Greek people understand only too well that they face declining living standards for some time if they want to remain in the eurozone, and, understandably, they don't like it.

Other countries are in very similar positions, and this creates a very difficult background against which to make wage decisions, because as JM Keynes famously said: "wages are sticky downwards."

These problems are exacerbated by regions with soft economies, where employment prospects generally are poor and deteriorating. Growth has slowed in major Organisation for Economic Co-operation and Development (OECD) economies, such as the US, the eurozone and Japan. These economies bounced back from the 2008/2009 recession nowhere near as strongly as is typical after a deep recession when spare capacity is quickly brought back into use. That didn't happen this time – hence, the weak recovery and current softening. Most countries are only just in positive growth, a position that compromises their ability to tackle unemployment.

Unemployment, which shot up during the recession, has remained very high. In the eurozone, it is around 10%, but this conceals some higher figures, such as the +20% figure in Spain. Unemployment is a lagging indicator, too, so it is likely to rise further given the current economic slowdown. And while this should, in theory, reduce the pressure on pay, that is certainly not evident at the top of organisations.

Added to this is the leading indicator of business confidence, which fell sharply at the beginning of this year, according to surveys throughout the US and Europe, with further adverse implications for investment and unemployment.

WHAT CAN POLICYMAKERS DO?

In truth, they have little flexibility, because the drivers of economic policy in both Europe and the US already have both feet on the floor. Interest rates are close to zero, and although there is some scope for monetary easing, this has nowhere near as powerful an effect in stimulating growth as reducing interest rates does. And on the fiscal policy side, there is no flexibility at all: indeed, high levels of fiscal consolidation (10% of GDP in the US and 4% in the UK) are required in many countries in order to get back into a stable position.

So the big question in terms of the macro-economy is: where we go from here? It is pretty clear that the economy has stalled, but whether it does so for a while and recovers or goes further downhill is difficult to predict. According to some analysis by Morgan Stanley on the four previous occasions over the past 50 years when the economy began to recover from a recession and then quickly stalled, in two cases the economy entered a double-dip recession and in the other two it picked up again. So the odds are 50:50 &nd but one may lean towards the pessimistic side considering that there are so few levers the government can pull to reverse the trend. The best estimate is that, for the time being, we are going to be in a pretty flat economic environment, with below-trend growth for the next couple of years. And within that scope, some countries face the additional challenge of trying to adjust their competitiveness within the eurozone. But it could be worse than that, and the risks are mainly on the downside.

LONG-TERM TRENDS IN PLAY

Income equality has been increasing in many countries for some years: top pay has risen much more than average pay, and pay in the financial sector in particular escalated dramatically before the crisis. Measured according to the "Gini coefficient", income became less equal in 19 of the OECD countries between 1985 and 2005, with the greatest discrepancy seen in New Zealand. Income inequality rose in the UK, too, though by less than the OECD average. However, the Gini coefficient is a very aggregate measure of income distribution and conceals a more disturbing trend.

For example, if you look at the top 10% and bottom 10% of incomes in the UK between 1975 and 2008, the top 10% have accelerated – a trend replicated in many developed (and developing) countries. And the disparity is even higher among the top 1% of earners, with the 10% of that top 1% seeing dramatic pay rises, pointing to a sort of "winner takes all" phenomenon right at the top of the income distribution curve. And in the banking sector, these trends are exaggerated further still, with relative pay (which started to rise at around the time of financial deregulation in 1990) now at an all-time high – even after the recession and government bailouts (at taxpayers' expense) of many banks. No wonder resentment about top pay in the financial sector runs so high.

Some particularly egregious examples of this phenomenon have served to focus this resentment. Harvard Business School researchers found recently that by 2008, share prices of Bear Stearns and Lehman Brothers had risen by four to four and a half times what they were in 2000, before collapsing to zero, leaving shareholders with nothing or next to nothing. Over the same eight-year period, the top five executives in each of those firms received more than £1 billion in cash. Such calculations demonstrate that things have gone too far and inevitably feed into policy thinking.

And these are not isolated examples. Separate research shows that between 2006 and 2010, investment banks were paying their employees, on average, 2.6 times pre-tax profits. This leaves very little on the table for shareholders and affects share prices, which, in turn, feeds through into pension funds and insurance companies and, thus, the wealth of individual savers. There is only one industry in which pay as a percentage of revenue rivals that of investment banks – Premier League football clubs in the UK. According to a special report in The Economist in May this year, in the 2008/2009 season, Portsmouth paid out more than 100% of its revenue in wages (it has since gone bust) and Manchester City paid out 95%. Five clubs beat UBS in terms of the percentage of income they paid out in wages.

But the bubbling resentment about top pay is about more than the politics of envy. There is some interesting academic research – led most notably by former Nobel Prize winner Joseph Stiglitz – that gives weight to the argument that this sort of top-wage inflation may have been central to the financial crisis. In the US in particular, but also in the UK, median incomes stagnated for 10 years or longer, and people compensated by increasing their credit, to the extent that household debt as a proportion of GDP rose to astronomical levels. People were essentially sustaining their living standards through credit, leading to the credit explosion that created the crisis. And, of course, high-risk credit was made available by banks, which, in the short term at least, made extravagant profits as a result.

So high pay is seen not just as an excrescence on the financial and real economy, but as comprising a set of trends that are central to explaining why our economy behaved as it did at the end of the last decade. This is why pay is such a toxic topic, and why the days are long gone when a senior Labour politician could say, as former Business Secretary Peter Mandelson did in 1998: "We are intensely relaxed about people getting filthy rich." No one in politics is relaxed about people making a lot of money these days.

POLICY RESPONSES TO HIGH PAY

Financial regulators, in particular, are taking a much closer interest in pay then they used to. Regulators formerly began by looking at the question of incentives and risk, but their interest now goes well beyond that, and, following a clear set of political instructions, that interest is spreading to the non-financial sector as well.

There has been a range of policy responses. Some are driven at a global level by the Financial Stability Board, instructed by the G20 finance ministers, and while implementation may differ in different regions, the changes are largely consistent. For example, regulators have required banks to disclose more detail on more people, to link incentives more closely to their risk appetites, to pay a larger proportion of bonuses in stock, to increase the deferred proportion of pay, and to introduce clawback mechanisms in order that bonuses may be clawed back if the expected profits fail to materialise.

In the US, shareholders have introduced "say on pay" resolutions, allowing shareholders to vote on remuneration committee resolutions – something that already existed in the UK. In some countries (notably the UK), finance ministries have imposed levies linked to bonus volumes. And some countries have imposed higher tax rates, which also, of course, affect non-financial employees.

REMUNERATION/COMPENSATION COMMITTEES HAVE AN UNENVIABLE TASK

Remuneration/compensation committees are operating in a difficult economic environment. They have to factor in complicated long-term trends that broadly show a growth in inequality, and they have to navigate a set of confused policy responses by the regulatory community. What's more, public and political scrutiny of their decisions is more intense – witness the column inches devoted to remuneration issues even in the UK's least-biased newspaper, the Financial Times. And yet competition remains fierce – the war for talent is by no means over, and the rising demand for particular skills at one end of the spectrum is helping to fuel the growing income inequality with people at the opposite end of the spectrum whose services, products or labour can be performed more competitively in the Far East or China.

An additional problem for public companies, particularly in the financial sector, is the growth in the number of private and unregulated firms (notably private-equity firms and hedge funds), which don't face the same disclosure constraints or exposure on pay decisions.

Finally, employee expectations have not adjusted well to this new environment – either in the financial sector or elsewhere. Employees still seem to think we will return to the good old days of the early 2000s, and that what we are going through at the moment is just an uncomfortable blip. But we are not going back there – we're not going to get the kind of returns we saw on financial equity in the run-up to the crisis anytime soon. This is an area where people have not properly focused on what is going on, so they don't really understand the changing trends.

HOW CAN COMMITTEES AND THEIR ADVISERS HELP THEMSELVES?

First of all, remuneration/compensation committees need to ensure that executives understand what has happened to relative earnings, because most don't. They also need to understand regulators' motives and anticipate further interventions. Moreover, they should prepare a public presentation of the impact of potential pay decisions in advance, rather than make the decision and worry about how to present it afterwards. And they should better model the incentive effects of the pay schemes they propose.

One of the things that have gone most awry over the past few years is the plethora of pay and incentive schemes that have driven the risk-seeking behaviour that has caused companies such serious problems. And those behaviours and problems aren't confined to the financial sector either. Recent work by McKinsey shows that the popularity of share buybacks over the past 10 years has been driven by earnings per share calculations for senior executives – if the earnings look a bit elusive, then you solve the problem by reducing the number of shares. That's not great from a shareholder point of view – you're pushing them to buy back shares when arguably they should be investing in growth opportunities instead. That phenomenon has not been as well understood as it should have been.

WHAT ABOUT THE FUTURE?

The economic and social trends in Europe in particular will likely maintain the focus on senior executive pay for some time. In many countries, incomes will not rise, and in some places they may fall. We are seeing that already, for example, in Ireland, which is achieving an internal devaluation much more quickly than the southern European countries that are under pressure. The Irish are increasing their competitiveness quite quickly and have been doing so in part by absolute reductions in pay – especially in the public sector.

In addition, relativities will likely be more in the spotlight and will require better explanations than companies have typically offered to date. What's more, public acceptance of high pay for high performance will be less certain in the future. Political rhetoric around pay is developing in a number of places and the mood is, quite simply, different. And public acceptance of pay for failure is now close to zero. So companies will have to be particularly careful around decisions to let people go with a large severance cheque to solve a problem.

ABOUT THE AUTHOR

Howard Davies was Director of the London School of Economics and Political Science from 2003 to 2011 and is one of the UK's most authoritative commentators on the financial services industry.

He was Deputy Governor of the Bank of England from 1995 to 1997. In 1998, he became the first Chairman of the Financial Services Authority, when the Labour government asked him to create a single regulator for the UK financial sector. He has also worked for McKinsey and Company and was special adviser to Nigel Lawson, Chancellor of the Exchequer.

Howard has published two books: The Chancellors' Tales, which tells the story of how the British economy has been managed over the past 30 years, as told by the former Chancellors of the Exchequer in both the Labour and Conservative administrations, and, with co-author David Green, Global Financial Regulation.

He is a regular commentator and journalist and a columnist for The Financial Times, The Times and Management Today.