May 2009

The Nation Reviewed

Incentivising

By Gideon Haigh
Illustration by Jeff Fisher.

An age-old conjugation of democracy runs something like this: I am guided by the will of the people; you are a slave of public opinion; he is a crude and craven populist. It was on show in March, during the crazy few weeks that began with the hounding of the hapless CEO of Pacific Brands, Sue Morphet, and ended with the lulling sensations of another Rudd government inquiry, this one by the Productivity Commission into executive remuneration.

While opinion polls suggested widespread disquiet about the handsome rewards enjoyed by chief executive officers, even for failure, an impressive body of editorials and op-eds sprang to the defence of the executive classes. There was Andrew Bolt ("Stupidity, class hatred and sheer jealousy have been on display this past week"); there was Michael Costa ("another childish attempt to blame our economic problems on executive greed"); there was Janet Albrechtsen chiding the Opposition for their pandering instincts, too (specifically for proposing "cheap, populist vote-winners safe in the knowledge no responsible government could ever enact them"). The Financial Review spoke with one, rather sulky, voice.

Some frustration was pardonable, faced with a shilly-shallying government that has rarely met an inquiry it did not like. But you'd hardly have guessed that the excesses of executive remuneration in the US have long had trenchant critics from within the ranks of business - that Warren Buffett, for instance, has described the issue as "the acid test of reform", and even urged shareholders to "rise up" against rapacious CEOs. And it was, to say the least, a piquant turnabout for the foregoing culture warriors, given their fondness for cheering "commonsense" majority views and railing against the treasons of "the elites".

Indeed, it is no longer merely telephone-number pay packets that are playing so badly with the public. It is the condescending contention that the people cannot be expected to understand the rationale for them. Strange that it has become a habit to praise Australians for their financial literacy and unprecedented levels of share ownership, yet insist that reservations about compensation are based on naivety and ignorance, and that it suffices for companies to operate in a Mugabe-esque environment of non-binding guidelines and non-binding votes. Stranger still, in a time when columnists and bloggers pontificate on such abstruse subjects as climatology and the geopolitics of Islam, that comment on executive pay from outside an approved, expert circle is regarded as gratuitously inflaming class jealousies or manifesting creeping socialism. Even in the freest society, the state is entitled to enquire where liberty degenerates into licence, and privilege into entitlement.

For Australia has never hosted a considered or rational debate about executive pay. Instead, we have tamely followed overseas trends, mouthed waffle about a "war for talent" and recycled justifications that don't withstand a minute's inspection, such as the tired trope of "superstars in sport and cinema are well paid, so CEOs should be, too" - as though the achievements of business are as straightforwardly ascertainable as the number of strokes on a golf course or the box-office takings of a movie - and the self-reinforcing argument that local bosses must at all costs be protected from the siren song of foreign enticements, which recalls the joke about the man scattering torn-up paper in order to keep the elephants at bay - and, on being told there are no elephants nearby, observing: "Effective, isn't it?" And while Australian executives are not chief among culprits for the current crisis, nor were they chiefly responsible for loose monetary policies and a 25-year bull market in equities, and they had no compunction about profiting from both.

The task for critics, meanwhile, is to come up with challenges to apologists for the status quo that cannot be dismissed as reflexive and politically opportunistic: questions that demand answers rather than merely assumptions. For instance, prove that financial incentives significantly improve corporate performance. Prove, beyond a shadow of doubt, by the most rigorous and scientific means, that extrinsic features like pay matter far more than intrinsic features like having a job with meaning and discretion. Prove that you can quantify the exact contribution, within a given financial year, of a single individual to the long-term profitability of an enormous corporation. Prove that the almost unfailing ability of executives to hit performance targets is not simply an indication that the targets are set for ease of hitting, rather than as a genuine incentive to outperformance. Prove that significant differences in pay do not impair collaboration and teamwork. Prove that paying a chief executive several hundred times more than the average employee does not convey the message that what the average employee does is of infinitesimal importance, thereby encouraging the phenomenon of the free-rider. Prove that a boss paid $5 million will be twice as effective if paid $10 million, and that increasing an executive's pay while wringing sacrifices and austerities from other workers is not profoundly demotivating and destructive to their allegedly common cause.

This last is given far too little attention, for it illuminates the stark differences between what we believe about executive pay and what we understand about pay in general - differences neatly expressed 50 years ago in a lovely primer, The Folklore of Management, by a much-admired American chief executive, Clarence Randall:

Let no one tell me that because a key executive has his year-end bonus increased by $50,000 he will accomplish that much more the following the year. Human motivation is not so simple. We in management do not ourselves accept this view of compensation where wage earners are concerned. We know from experience that explosive advances in the hourly rate do not pay for themselves by an equivalent increase in productivity. If human motivation could be calibrated that easily, all a company would need to do in order to double production would be to double the wages. Why then should we behave as though giving frequent large increases to company officers would bring about an equivalent forward thrust in executive effort?

Sounds like a very good question. Sounds, in fact, like a question on which an intelligent layperson could probably express an opinion. And, again, why should the public not have a view, and why should it not matter? After all, you could turn the argument around and say that executives and directors are the last people whose views should be trusted on matters of compensation, because they are so hopelessly conflicted and implicated in them. As Randall observes elsewhere: "Unless the chief executive's conduct has been subjected to the critical judgement of persons who have nothing at stake, he has not measured up to the standards required for a clear conscience."

Notwithstanding efforts to paint this as a "complex issue" - as though complex issues are somehow rare and exceptional - executive pay is in an important sense very simple, a subject requiring neither specialist scientific background nor deep historical knowledge. For not only is the experience of pay for work a universal one, but the concept of pay for performance has become almost ludicrously pervasive, as the Stanford management scholars Jeffrey Pfeffer and Robert Sutton note in their most recent book, Hard Facts, Dangerous Half-Truths and Total Nonsense:

Incentives has emerged as the first answer to almost every problem. Are your schools failing? Bribe teachers with incentive pay. Is the medical system inefficient? Set up a managed care system that provides financial incentives to doctors, insurers, patients and hospitals. Bad customer service? Provide financial incentives for better customer service. Airplanes not flying on time? Pay employees if the planes fly on time. Too much overtime in garbage collection? Give truck drivers a financial incentive to finish early. Stock price not high enough? Give senior management financial incentives to get the stock price up.

In fact, this economic climacteric offers an opportunity for business to look again at its reliance on a straightforward financial cosh to secure obedience to collective goals, and to redress the crude, punitive, dehumanising conviction that we work for money alone - for the very good reason that there is now a great deal less money to go around. The companies which have, over the past 20 years, outsourced a growing proportion of their executive payroll to the stock market through equity-based remuneration have finally polished off that magic pudding.

Populist? Sure. But so what? In This Is Spinal Tap, the members of the spoof heavy-metal band are asked about the cover of their album Smell the Glove, which features a scantily clad woman down on all fours, being led by a leash. Isn't it a bit, y'know, sexist? Replies a band member: "What's wrong with being sexy?" Expect a paraphrase from Wayne Swan: "Populist? What's wrong with being popular?"

Cover: May 2009
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