Think-tank calls on companies to reduce pay inequality

The British New Economics Foundation (nef) today released a report, The Ratio, which suggests forcing companies to reveal the ratio between their bottom and top pay level. One of the report's authors, David Boyle, says:

"For too long, campaigns against corporate greed and ever-widening pay ratios have tended to be defensive and negative.  They have been campaigns against rather than campaigns for equity, or anything else.

"This needs to change partly because having a compressed pay ratio is not just a good thing ethically.  Nor is it just a better way of motivating staff and providing greater equity in society, with all the economic benefits that will bring.

"It is also a sign that a company is sensitively, fairly and imaginatively run, that its management and board understands the role that all their staff can play, and that collaboration inside and outside the company is as important to their success as competition.

"It is our contention that a more effective corporate form is emerging based on these ideas.  Many of these will be co-operatives, but some will simply have a more co-operative spirit that understands the need to include staff and use their resources more effectively.

"In time, these companies will push aside the kind of corporate dinosaurs that minimise the pay of their lowest and maximise the pay of their highest echelons, a sign of fatal inflexibility and short-term thinking."

Extracts from the report are below, and you can download it in full here.

The divided world

The deregulation of finance since the late 1970s has accompanied a negative redistribution of the benefits of economic activity. For example, in the 1980s, the share received by those living in absolute poverty from a notional $100 worth of global economic growth was already an unimpressive $2.20, but a decade later that share had shrunk to just $0.60c. The world has experienced not the promised wealth ‘convergence’ of economic theory, or even the famous trickle down. Instead there was a ‘flood up’ of wealth, from poor to rich.

Free of the shackles of office at the International Monetary Fund, its former president, Michel Camdessus, who both presided over and agressively promoted financial deregulation, commented in his retirement speech in 2000 that:

"The widening gaps between rich and poor within nations, and the gulf between the most affluent and most impoverished nations, are morally outrageous, economically wasteful and potentially socially explosive. Poverty will undermine the fabric of societies through confrontation, violence and civil disorder."

Better late than never, some might say, but a shame that the economic model in which he placed so much faith had pushed those “morally outrageous, economically wasteful and potentially socially explosive” gaps ever wider. Between the top and bottom fifth of all countries, the gap has grown from 3:1 in the early nineteenth century, to 30:1 in 1960, to nearly 80:1 now. This, though, is separate to the growing inequalities also within countries.

The costs of inequality[1]

Inequality damages people and imposes signifi cant costs on society. It also makes it harder to tackle some of our most pressing challenges. In unequal societies people die sooner, are more prone to obesity and a higher proportion of children die in infancy. Conversely, mental illness is less likely where society is more equal. More equal societies suffer less abuse of illegal drugs, their children do better at school and have higher levels of well-being according to measures used by Unicef.

Levels of trust, vital for well performing firms, are higher where equality is greater, and society less harsh and punitive, with lower homicide rates, less experience of violence among children and a smaller proportion of people being imprisoned. Positive self-reinforcing feedbacks seem to correlate with greater equality and the opposite appears true for higher inequality.

The great mistake: how money fails to motivate

Many things created the circumstances in which executive pay rose to previously unimaginable levels: the rising power of finance, the loosening and loss of corporate governance models more prone to the equitable distribution of benefits, the closed self-reinforcing world of the globe-trotting CEO.

Perhaps greatest of all, though, is the seemingly unchallengeable notion, etched into ‘common sense’ economics, that you get what you pay for. And, if you pay more, you will get more from top bosses. The only problem with this untouchable article of faith in business management, is that it is doubtful. In his book Drive: The Surprising Truth About What Motivates Us Daniel Pink cites research summarising the findings from 128 experiments. The consistent outcome observed was that, “tangible rewards tend to have a substantially negative effect on intrinsic motivation”.

Writing earlier, the psychologist Alfie Kohn comments that: “Not a single controlled study has ever found that the use of rewards produces a long-term improvement in the quality of work. Rewards usually improve performance only at extremely simple – indeed, mindless – tasks, and even then they improve only quantitative performance.”[2]

In a now famous experiment, quoted by Pink, a group of economists from the Massachusetts Institute of Technology, the University of Chicago and Carnegie Mellon were funded by the Federal Reserve Bank of Boston to observe the influence of financial incentives. What they found astonished many. Rewards worked well in only very limited circumstances when the tasks in question were simple, ‘mindless’ and mechanical. The moment that any other cognitive skills were demanded, even rudimentary ones, the influence of a financial reward not only failed to incentivise better performance, it made things worse. “In eight of the nine tasks we examined across the three experiments,” observed the researchers, “higher incentives led to worse performance.”

Their findings were corroborated by separate research at the London School of Economics which found that, “financial incentives can result in a negative impact on overall performance.”

From MIT, to the Federal Reserve system and the LSE, here was ‘the establishment of the establishment’, as Pink put it, coming up with findings to contradict their core philosophy. Using pay to reward and motivate senior executives, and often disproportionately compared to the contributions of other staff, was found not only to be divisive, and socially damaging with real costs attached for the wider community, it was also economically useless and actively damaging for the individual on the receiving end of the remuneration committee’s largesse.

Experimental results on high pay as a disincentive for performance have been in the literature for decades. But it is yet to cross over into mainstream business practice, which has huge disadvantages for investors which need, as a result, to know which companies have genuinely effective pay policies.

The challenge: how to reward real contribution

But, going further still, when different metrics are applied that attempt to capture the social benefits of the contributions made to society by different professions, some startling inversions of current practice can be revealed. Using a tool called Social Return on Investment, nef found that pay and the actual social and environmental value of work can be inversely related. The study, A Bit Rich concluded that:

-Leading City bankers on salaries of between £500,000 and £10 million destroy £7 of social value for every pound in value they generate, whereas…

-For every £1 they are paid, childcare workers generate between £7 and £9.50 worth of benefits to society.

-On a salary of between £50,000 and £12 million, top advertising executives destroy £11 of value for every pound in value they generate, but…

-For every £1 hospital cleaners are paid, over £10 in social value is generated.

-For a salary of between £75,000 and £200,000 tax accountants destroy £47 of value for every pound in value they generate, yet…

-For every £1 of value spent on the wages of waste recycling workers, £12 of value will be generated.

Not only does there appear to be an urgent need to reverse the widening pay gap, but also to produce a more rational basis upon which to decide remuneration. Public attitudes are shifting decisively in favour of action. In evidence to the High Pay Commission, Liane Hoogland from the University of Sheffield cites a ComREs survey for the BBC showing strong support for lower incomes to be higher, and higher incomes to be lower. A more recent survey commissioned by the Institute for Public Policy Research found 82 per cent in favour of government intervention to close the pay gap.

Yet resistance to change is deeply entrenched. In the aftermath of the bank crisis, John Varley, then Barclays’ chief executive, reacted in horror to the suggestion by a BBC Radio 4 interviewer that some parameters should be put around pay and bonuses awarded to bank staff. It would “interfere with the market,” he said, despite the fact that the banking market had at that stage been interfered with in the form of a public bail-out, or it could not have survived.

What can be done to return common sense to executive pay and reduce inequality? This report is not concerned with the level of executive pay in itself, but with the widening gap between pay at the top and bottom of companies, and between the top and bottom of society. This gap is usually expressed as a ratio.

What next?

The publication of the crucial ratio between lowest and highest paid in every public company would encourage debate about pay and corporate responsibility. It would, we believe, kickstart a more informed debate about what kind of pay gap is acceptable and what is simply divisive and inflationary. It would also have a healthy effect on both fairness and equity in the UK, and on the companies themselves.

One of the more surprising revelations, shocking even, is the absence of any evidence to support and justify high pay ratios, compared to the large body of evidence concerning the costs of inequality. We believe that the burden of proof should shift, so that companies operating a ratio above 1:20, or even 1:10 (this is the debate we need to have), would need to show how the economic and social benefits of doing so outweighed the costs. Our recommendation is that every public company should be required to reveal this, and also companies seeking government contracts which are over a certain size.

The sooner we can make this happen, the sooner it will start drawing investors’ attention to what are the most important and relevant aspects of corporate pay. While disclosure of size of CEO salaries, as happens now, may simply tempt remuneration committees into greater levels of excess, disclosure of the ratio can potentially shame or guide the corporate world into more equitable arrangements – or to explain why they are genuine exceptions.We also believe that this will be good for the companies themselves. It will allow them to row back the levels of greed and excess that have prevailed over the past decade. That alone will save them on average around five per cent of their annual revenues (if they are to return to 1993 levels of CEO pay) which they are paying so inefficiently at present.

It will also require them to take some account of a measure of equity that we have known for some time is also an indicator of corporate success. Exactly how that success might be measured requires further research, but companies that had a lower pay gap, as revealed in their ratio, are demonstrably better corporate citizens, with longer time horizons and a better understanding of the value of their own staff . We also know there is a link between high quality work and pay equity within companies.

[1] Wilkinson, R. & Pickett, K. (2009). The Spirit Level: Why More Equal Societies Almost Always Do Better. London, Allen Lane.

[2] Kohn, A. (1999). Punished by Rewards. Boston: Houghton Mifflin.