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Why CEOs make so much money

It seems like the salaries of big-time CEOs just keep getting bigger. But why do they make so much, and has it always been this way?

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At around 1730 on Wednesday 6 January, about 34 office working hours into 2021, bosses of top British companies had earned the same amount that an average worker in the UK earns in an entire year.

According to research from the High Pay Centre, an independent think tank based in London, FTSE 100 chief executives earn a median of £3.6m ($4.9m) a year – more than 100 times the £31,461 earned by full-time employees. At the top of the pile of those CEOs is Tim Steiner, chief executive of the online supermarket Ocado, who was paid £58.7m in 2019. That's 2,605 times the company's staff on average. In one day, he earned seven times their annual salary.

Across the Atlantic, the picture is even more extreme. Analysis by the Economic Policy Institute, a Washington DC-based think tank, showed chief executives of the 350 largest US companies earned an average $21.3m (£16.9m) in 2019. This puts the CEO-to-worker pay ratio at 320 to 1 – more than five times the level in 1989.

These findings come as the coronavirus pandemic has worsened inequality across the world, exposing low-income populations to greater health risks, job losses and declines in wellbeing. These divides have come into sharper focus than ever as awareness grows of the value of 'essential' workers – who often have few employment rights and little pay.

The result is mounting confusion and anger over the extraordinarily high salaries that top bosses continue to earn. With these deep-set inequalities laid bare, the question for many is how these huge pay packets ever came about. By whom and how they are given the green light and, crucially, should they continue to have a place in post-pandemic society?

Some people see high pay appropriate for visionaries like Elon Musk, but these pay packets are more perplexing for average CEOs, who aren't exceptional talents (Credit: Alamy)

The roots of 'price-driven salaries'

The executive pay gap has its roots in the policies put forth in the 1980s by the Reagan administration in the US and the Thatcher government in the UK. Their political philosophies drove deregulation, privatisation of the public sector and free-market capitalism. Both also took a dim view on labour unions, which ultimately played a role in these organisations' reduced capacity to advocate for workers.

"If you go back to the early part of that period, it was very common for executives' jobs to be part of a company's overall job-evaluation system. There was one system to evaluate everybody's pay," says Sandy Pepper, an expert in executive pay at the London School of Economics. This month, Pepper published a paper exploring why the pay gaps have opened up between CEOs and the wider workforce.

But he says the previous system "broke down" when executive pay became connected with share prices, and "asset-based rewards" took off under the prevailing neoliberalism. Pepper's analysis of FTSE 100 data since 2000 showed that all-employee pay has increased about 3% a year on average, but CEO pay increased about 10% per year.

Pepper says the underlying logic was to pay the CEO according to a company's financial performance, since they were the most important factor of success. So, on top of basic salaries, CEOs were given performance-related bonuses and stock options allowing them to buy company shares for a set price. Ocado CEO Steiner's 2019 pay packet included a bonus of £54m for realising a five-year "growth incentive plan", which measured the company's share-price growth relative to the FTSE 100. (Ocado declined request for comment.)

At the same time, the proportion of UK businesses owned by individuals dropped precipitously. Shareholders grew in power, and their demand for booming stock prices led to booming pay packets for CEOs – in turn signed off by boards of directors eager to please their investors.

Robin Ferracone, CEO of Farient Advisors, an international executive-pay consultancy, agrees with these "price-driven" salaries. "If you have a good CEO, the multiplier effect can be huge," she says. "So, in principle, median pay for median performance and high pay for high performance makes sense."

Walking on eggshells

However, in reality, the system of calculating CEO remuneration is more complicated. Companies rely on compensation committees, mostly made up of board members and executives from other companies that meet once a year.

Besides the more traditional measures of past experience and performance, committees use benchmarking as a key part of the process – working out how the CEO's compensation will compare to those at similar companies, according to Steven Clifford, a former CEO and author of The CEO Pay Machine. Often the sum will be in the 50th, 75th or 90th percentile, therefore constantly maintaining or increasing pay, he writes.

A study in 2010 in the Journal of Financial Economics concluded this system of compensation committees is accelerating pay inflation "because such peer companies enable justification of the high level of their CEO pay".

Bonuses are then agreed as a way to measure performance, either increasing based on financial measures or provided in sum if specific goals are met.

As shareholders have grown in power, their demand for high share prices has nudged up CEO pay (Credit: Alamy)

Both the process for base pay and for bonuses are seen by workers' representatives as problematic because boards, not wanting to upset the leader of their company who could leave or fire them, therefore push up pay.

Janet Williamson, senior policy officer at the UK's Trades Union Congress, argues the system of compensation committees, who often report directly to the CEO, lacks impartiality and should be reformed. "We need to move away from performance-related pay – that's what has led to these increases," she adds.

In fact, Pepper argues the empirical evidence shows the strongest correlation between pay and company financial measures is not financial performance, but rather the size of companies – there is simply more money to spend. "The bigger the company, the more CEOs are paid," he says.

'CEOs are key to success'

Whether CEO pay is justified remains subject to fierce debate. On one side, free-market economists argue high executive pay is justified if it aligns with the interests of executives and shareholders. If businesses are willing to pay these sums, they say, that is value that the market thinks the executives are worth.

"CEOs are key to success," says Daniel Pryor, head of programmes at the Adam Smith Institute, a neoliberal think tank. "It's quite clear there are a limited number of people that have the skills, the personality and disposition to be the CEO of a top company, and those limited number of people are highly sought after."

Pryor points to the examples of Steve Jobs at Apple, Jeff Bezos at Amazon and Elon Musk with Tesla and SpaceX, exceptional talents who've forged revolutionary technologies from the ground up. Yet a number of researchers say that the role of the average CEO – a managerial type that hasn't founded the business and hasn't been a visionary – is overstated. Rather, other factors are more important in deciding the fortunes of a company.

"There are several reasons a company can perform well," says David Bolchover, a management-pay expert who wrote the book Pay Check: Are Top Earners Really Worth It?. "Maybe the economy or their sector is buoyant, which has nothing to do with the CEO, maybe they operate in an oligopoly. It could be the contribution of workers. The impact of a CEO on company performance is not measurable, which is the nub of the issue. They have this 'talent ideology' to justify this. But is their ability so rare? I think it's a con."

Bolchover says the 2008 global financial crisis is a prime example of how performance and pay don't always align. "The financial sector always defended their high pay on the basis of their rare abilities and their talent," he says. "But a lot of these banks went bust during the crisis, and people started to ask questions – why were they paid so much and why did they continue to be paid so much even after the crisis?"

According to Bolchover, the "vortex of self-interest" between shareholders, board members and executives is why CEO pay has not dipped – and, for him, that is why there is growing pressure from the general public.

'A dramatic step forward'

While top-brass pay keeps sailing on, employee rights seem to be on a downward trajectory – especially for front-line staff amid the pandemic. For many average workers, these huge numbers have become an increasingly bitter pill to swallow.

Workforce anger at this pay disparity spilled over earlier this month when thousands of employees at British Gas went on a five-day strike in response to plans to reduce the workforce and shift employees to new contracts with fewer rights. Tensions had already been boiling since 2018 after the chief executive of Centrica, the company which owns British Gas, received a 44% pay rise to £2.4m.

Workers for large companies in which CEOs earn big are becoming more agitated at the pay gap, especially as inequality persists (Credit: Alamy)

"It's the greed and it's the grab," says John, a 32-year-old worker at British Gas, whose name has been changed due to job-security concerns. "It's more than the prime minister gets paid. How can they justify it? When you're paying that much money, it doesn't mean you're getting quality, but you're getting a certain kind of person from a certain kind of background." (Via email, a Centrica spokesperson commented that the base salary of the company's current CEO is 19% less than the previous CEO, and that during 2020, neither the CEO nor executive directors received an annual bonus or any annual pay increases.)

There are signs, however, that the rise of CEO pay is at least slowing. Paul Lee, who has worked as an investment consultant for 20 years, says that CEO pay in the UK has "plateaued" in recent years, "but the level has been around the £4-to-5 million mark for several years".

Lee believes the changing mindset of institutional investors and sovereign wealth funds is behind this recent stalling in salaries. They invest in these high-paying companies, but are ultimately funded by the general public – through pension and investment funds – and are aware of the growing unease. "Are those numbers justified? It's really hard to say objectively," he says. "But there's a growing atmosphere of accountability. Partly because of a debate in the public, partly pressure from the government."

For instance, in the US, Senator Elizabeth Warren's draft Accountable Capitalism Act proposes time limits on company stock sales, in an attempt to shift the focus from short-term shareholder returns to the long-term goals of all stakeholders. There are also emerging initiatives like those in San Francisco and Portland, where businesses are taxed if their pay ratio is too high, creating an explicit economic incentive for greater equality.

And, amid the pandemic, executives at some top companies including Boeing, Marriott International and PwC have voluntarily sacrificed some of their pay to save staff jobs in 2020 – though many criticise this as a token move.

Luke Hildyard, director of the High Pay Centre, says companies can take further meaningful steps to reduce the pay gap, such as worker representation in boardrooms, and better reporting of company pay data to increase accountability. Company earnings could then instead be distributed more evenly across the workforce.

"Improving those normal peoples' lives with relatively small increments of money could be transformational," says Hildyard. "That would be a dramatic step forward."

For Hildyard, the eye-watering CEO figures are "startling" evidence of a growing societal divide. "The UK is one of the most unequal countries by income in the developed world, and that has risen in tandem with the rise of executive pay." He argues this is significant because research shows that unequal countries tend to do badly on measures including social cohesion, public health and wellbeing, crime levels and education. Higher levels of inequality mean society suffers.

With a global economic recession on the horizon as the pandemic rages on, Hildyard believes "scrutiny of inequality" will heighten. He says the growing role of the finance industry, the outsourcing of low-paid work and the decline of trade unions are behind the widening inequality gap over recent decades. "At the same time, those at the top have not only maintained their wealth – but seen it grow massively," he adds. "If that trend continues, society will become even more divided and workers will suffer."

Update 27 January 2021: This story has been updated to include a comment from Centrica.

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Source: https://www.bbc.com/worklife/article/20210125-why-ceos-make-so-much-money

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