Equality in executive pay is not always fair

 24 May 2017

"High and unwarranted executive pay is an issue that needs to be addressed for the benefit of society as a whole." So said the UK parliament's business, energy and industrial strategy (BEIS) select committee in its recent report on corporate governance, reflecting the mood of the times.

It called for a suite of interventions including stronger voting powers for shareholders, publication of pay ratios, and employee representation on remuneration committees. The manifestos of the UK's main political parties suggest whoever forms the next government will follow through with similar ideas.

But will they address the real problem? "Why People Prefer Unequal Societies", a recent paper in Nature, the scientific journal, argues that the focus on inequality is overdone. What people actually want is a fair society, not an equal one. There is a vast literature arguing that human beings are hard-wired to want a just and proportionate relationship between effort and reward, not equality. But it would be dangerous for the business community to jump on this as evidence that nothing needs to be done. Poll after poll shows a chasm between pay practices in the boardroom and what is viewed as acceptable by the public.

It would be unjust to say that boards ignore pay fairness. But not enough have created a holistic framework within which organisational equity, including pay, is judged. This has allowed some businesses to be seduced into a one-dimensional, market view of fairness that justifies adopting minimum standards and reduced worker security at the bottom, while continuing to march to the beat of benchmarking for the most senior executives. This has created the demand for the publication of pay ratios. But pay ratios just replace a one-dimensional view of fairness based on the market with a one-dimensional view based on equality.

The policy report of the purposeful company project established by the UK's Big Innovation Centre, a consortium examining how to support the development of value-generating companies, calls for an ambitious reframing of the debate on pay fairness in companies.

First, directors take the definition of their duties seriously, so it is important that these duties are clearly understood by all concerned. Under directors' obligations to wider stakeholders, as set out in Section 172 of the Companies Act, boards are expected to develop clear principles on fairness in relation to pay and conditions, and to satisfy themselves that those principles are being implemented by executive management. This would most likely be expressed through broadening the remit of the remuneration committee so that it is accountable for overseeing pay fairness.

Developing these principles would need the support of a new language on pay fairness. Boards would need to consider how they balance fair reward for market worth with fair reward for contribution. How do they consider internal proportionality of pay and the assurance of minimum wages to enable employees to lead a dignified life? Equal pay for equal work must be expressed as an underlying principle, but this should not lead to boilerplate language. Thoughtful boards would recognise that a mature employee-owned co-operative may apply different weights to the dimensions of fairness than a high-growth technology start-up.

Second, a fair pay report should require the board to report on its principles and how they are enacted. This should incorporate a mix of standard disclosures - including pay trends for the chief executive and average employee - with narrative disclosure providing further context relevant to the company in question. Reports need to be similar enough to prevent issues being ducked, but broad enough for companies to reflect their own circumstances. The emphasis should be on principles not detailed regulation.

Third, inject the tension of seeking the employee view. Given the variety of business circumstances and cultures, the mechanism for this should not be prescribed, but should be expected to be meaningful. This could range from employee representation on board committees, through use of stakeholder panels, union engagement and company employee general meetings, to creative use of information and consultation mechanisms. The challenge of creating an effective engagement mechanism for complex multinational organisations should not be underestimated. Experimentation should be encouraged, and progress may require several steps.

This could be accused of just being deadening bureaucracy, but it should not be. Systematic, large-scale research by Alex Edmans, professor of finance at London Business School, shows that focusing on employee wellbeing improves company value by 2-3 per cent per year. Done the right way, a fair pay process will help boards build trust and engagement with employees, and enhance productivity.

As the BEIS committee rightly said: "All parties need to be sensitive, and respond to, the shifting sands of opinion about fairness of rewards." A good starting point is for boards to be clear what they mean by "fair". If we fail to rise to this challenge we can predict trouble ahead.

Tom Gosling is a partner at PwC and member of the steering committee of the purposeful company task force

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