Great Expectations

By Ian Davidson, Consultant

I was recently talking to one of the most erudite and intelligent of the global banking HR Directors in his Singapore office.  We were discussing the issue of high pay; both in financial services and elsewhere.  Having always taken the view that high revenue producers were entitled to a share of the profits; his comments caused me to stop and think more deeply about my belief. The HRD said that there was no “entitlement” to high pay.  Yet, there is, in my experience, a strong sense of entitlement among many who are in that category.  That generated for me the question as to why some people get high pay. 

There are four broad approaches to why people get high pay:

  • Happy circumstances – having the right parents, being born at the right time and place – as per Malcolm Gladwell.
  • An entitlement to a proportion of the revenue made by an individual’s effort.  One is strangely reminded of the old Clause 4 of the UK Labour Party constitution; “To secure for the worker, by hand or by brain, the full fruits of their industry and the most equitable distribution thereof….”  I do not think mega-pay is quite what Sydney Webb had in mind when he wrote those words. (The clause goes on to talk of common ownership – yet look what has happened to the Co-operative Bank).
  • The Labour Market – the economic argument that we are paid what the market needs to pay us to balance supply and demand. 
  • Tournament theory – Tim Harford, one of my favourite economists writes on this subject.  Basically, this theory explains that your boss is overpaid in order to get you and your colleagues to try hard to compete to get her position.  As Harford states in the article:

    “The economists Edward Lazear (recently appointed to chair the Council of Economic Advisors) and the late Sherwin Rosen argued, in a hugely influential paper published 25 years ago, that tournaments are an integral and often invisible part of the workplace. Workers are frequently ranked relative to each other and promoted not for being good at their jobs but for being better than their rivals. It is a natural response to the difficulty of true performance pay."

The answer as to why some people have high pay, and not others, is going to be a mixture of all the above; complexity befuddles and obscures what should perhaps be obvious in the discussions around high pay.

Approaches to high pay:

Happy circumstances

There is a school of thought that most of the elements that lead to someone having high paid are “happy circumstances”.  This is the argument put forward by the American Philosopher John Rawls that was very amusingly and effectively argued by Professor Michael Sandel in his Harvard lectures.  Malcolm Gladwell makes the case in a more populist way in his book Outliers.  Likewise as Nobel Prize-winning economist James J. Heckman has found, 50 per-cent of lifetime-earnings inequality is determined by factors present in the life of a person by age eighteen.  (Quoted by David Brookes in “Social Animal”).  Thus, much to do with parents, place and time of birth – happy circumstance. 

These are powerful arguments as to why some people are high earners.  It does undermine, although not fatally, my belief that those making high revenue should be entitled to a proportion of this profit.  It is a strong argument in favor of a high level of redistributive taxation.  It is not, however,  directly, an argument against high pay; it is just an explanation; although accepting the argument of happy circumstance does create a framework for thinking about equality and social justice that is discussed in a later article.

The issue here is that this theory explains why some people get in to high paid roles – but not why those roles are high  paid.

An entitlement theory

I have always believed that if an employee makes a large amount of money for their employer, then she is entitled to a proportion of that revenue.  The thinking is that the profit was made due to the skills, diligence and application of the individual.  Without this effort the shareholder would see a lesser return on their capital.  In the bank where I worked there was a desk head that was paid more than ten million pounds a year.  However, this was less than 2% of the revenue she made for the Bank.  This individual had invented an innovative financial instrument that she then sold in vast numbers to private banks in a specific geographical region.  I would argue that the number of people that have the intellectual ability to develop a financial instrument that is both useful and popular; together with a personal network of contacts in a specific banking sector of a specific geographic region to whom to sell the product, can, on a world-wide basis, be counted on the fingers of one hand.

Jeremy Clarkson, the UK motor car commentator is alleged to have earned something over fourteen million pounds last year.  He did so on the back of highly successful sales of both the TV program he presents and the related mechanising.  It is clear that without him the program would not have been so popular, generated so much revenue or made the BBC a considerable profit (and I will talk of BBC management salaries and payoffs later in this article). 

David Beckham, my favourite sports personality makes millions for his personal brand every year.  But, as the saying goes, “there is only one David Beckham”.  A mixture of very astute marketing together with one of the nicest personalities you could hope to meet (I understand, I have never actually met him), has earned him enviable amounts of cash.  He has also generated very large amounts of money for the various football clubs he has played for – both in ticket sales (you paid how much for a season ticket!)  and for merchandising. 

There is a strong argument that even if the individuals got to where there are by “happy coincidence” they have capitalised on this to make a large amount of revenue for their employer, capital supplier or business partners.  The concept of “fairness” would seem to indicate that they should share in the wealth generation for which they are responsible.


The labour market argument

The most common, and in some ways the most “acceptable” argument is that it is the labour market that decides who gets what, or rather which roles get best paid.  Salary surveys’ gather data on a large sample of people employed in roughly the same roles and produces analysis such as the median, the quartiles for the role salary range and other related information.  Organisations spent a very large amount of money to obtain reliable data on the market price for roles in their organisation.  The argument is that the market sets what an organisation needs to pay to attract and retain staff. 

The linked economic argument is that employers need to pay for skills and experience that are both in demand and in short supply.  The price (remuneration) will go up or down until the supply and demand match. 

There are a number of problems with the labour market approach.  First and foremost, the labour bazaar is nowhere close to being a perfect market.  That is there are a lot of imperfections in the market for labour that means it does not work very well.  For example, there is no “perfect” information.  Not everyone in the labour market knows all the supply, the demand or the equilibrium price.   There are massive labour market distortions caused by government intervention and there is not equal access to the factors of production; to name but a few issues. 

The other problem, linking back nicely to the argument and the post title is that labour market’s create “Great Expectations.”  In a commercial organisation, the “price” of the CEO or CFO, for example, is set by the market.  However, if they do not deliver the shareholders have the ability to remove them from office.  Given the average tenure of a FTSE250 CEO is around four years it looks as though that power is exercised somewhat frequently. 

However, if you work for the BBC, the NHS or a charity you use the same labour market to establish “value” but without the same level of accountability.  The argument used by the BBC, for example, is that they need to pay market salaries is facetious.  Has it ever been tested?  The BBC takes, under criminal penalty, money from the population of the UK, who have no say in the pay or employment of highly paid managers.  To use the excuse that they have to pay a market rate is to ignore the completely different nature of a commercial organisation with one in the voluntary or monopoly sector.  This argument holds for charities and for the NHS.  I am not particularly attacking the BBC, who, most of the time, do an outstanding job; but illustrating the problems of labour market data. It can be argued that the reason the BBC does an outstanding job is because of the strength of the management – but I wait to be convinced on that one.

I argue that while salary surveys provide a market framework they are not of themselves, the labour market. 
What salary surveys’ do is give an indication of the relative value of scare skills and resources of individual actors filling groups of roles (and less us not forget, salary surveys’ measure roles not individuals) within a competitive market place.

I worked with an outstandingly good member of a remuneration committee called Ian D Cormack who is chairman of a number of remuneration committees.  He is a very thoughtful observer of executive pay.  He noted that the payment of executives was a cost of doing business.  The issue was to decide what proportion of the profits went to the “talent” and what proportion went to the capital providers.  He also noted that when a company was not making profit, the talent still might need to be paid a bonus under the “cost of doing business” – as the alternative of not paying a bonus may be far more expensive for the shareholders.  He was also very keen to explore what executives were being paid for and what they were being reward for (note the difference).  On other words, was the reward package properly aligned with business and strategic outcomes?

These types of discussions place the role of the labour market and salary surveys in a much wider context than simply the mechanical exercise of market pricing.  This is before we start to consider the role of high pay in society; the concern of another article.

Tournament theory

I like tournament theory.  It is an interesting and intuitive explanation for high pay.  To get high pay you do not need to be the “best”, just better than all the rest (tip of hat to Tina Turner).  As a reward specialist of many years standing I have to say that this works in practice as well as in theory.  This is one of the effects of the labour market being “imperfect”.  There is something of an argument that organisations put up with less than best performance because the cost of replacing the “not best” performer is large and very risky.  It is difficult to tell at recruitment if someone is going to be a top performer or not. 

While tournament theory is very attractive it does not really fill the gap in thinking about high pay.  The millions that are paid to the CEO of a FTSE company are far more than would be necessary to encourage talented individuals to step up to the plate.  It is an important part of the high pay narrative – but only a part.

Conclusion

There are a number of convincing theories why some people get high pay and other do not.  None of them are, on their own, a complete explanation; even together they do not provide a sense making framework of explanation.  High pay is important, useful and I would argue, perhaps in a moment of controversy, essential.

Why is this lack of sense making frameworks important?  There is a great deal of attention, much of it misinformed, as to why some earn millions and some earn a pittance.  A modern, democratic society needs to be aware and understand what drive the actions and rewards of economic actors.  Otherwise, as is the case today, policy making around the subject is poor, misinformed and full of unintended consequences.  Much more thought needs to go into subject by politicians and those who advise them so we can have some grown-up conversations about the role of high pay in modern society and, if necessary, any limitations or caps – although history has shown these approaches do not work and cause, again, a mess of unintended consequences. 
High pay is important as part of economics and social policy.  Sometimes there are some unpalatable facts behind the framework – particularly if the “happy circumstances” argument is accepted.  HR and the reward profession have a major part to play in the interesting road of discovery that lies in front of us. 

Attend the next Reward Forum event:
Reward Trends, Challenges and Opportunities.
28 November 2013

Thank you for your comments. There may be a short delay in this going live on the blog page as we moderate the comments added to our blogs.

  • Anonymous
    Anonymous

    It is very easy to compare cost of living and the expected salary when you move to a different country or city to work as expat. There are tools that generate cost of living reports and analysis that helps you understand. I remember a site called www.salaryexpectation.com