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24 July 2014updated 22 Oct 2020 3:55pm

Ed Smith: Megabucks executive pay isn’t a reward for excellence – it’s a corporate contagion

American banker J P Morgan argued that a company’s top brass should never earn more than 20 times what those at the bottom do. Such a ratio now sounds laughably idealistic.

By Ed Smith

Take a bow, Burberry shareholders. Their rejection of the £28m pay package offered to the company’s chief executive, Christopher Bailey, is a rare example of common sense pricking the bubble of executive pay. The shareholders’ wishes may yet be ignored but they will remain right.

Three issues should make us doubt that an employee, however talented, is worth almost £30m (the package included an “annual allowance” of £440,000 on top of a £1.1m basic salary and shares worth millions of pounds). First, we overestimate our capacity to distinguish between luck and skill. Second, in a competitive industry, the gap between executive pay and average salaries is far from logical. It is a relatively new invention, designed by and for the managerial class. Third, exorbitant salaries, routinely justified as inevitable due to “competition”, are better explained in terms of contagion. A few absurd salaries become the justification for ludicrous pay across a whole industry.

In pointing out that it is hard to disentangle luck from skill, I am not arguing that Bailey is merely lucky. Yet precisely identifying causality in business is difficult. As Phil Rosenzweig describes in The Halo Effect, we tend to rush to anoint superheroes, even on shaky evidence. The truth is that the origins of success often pre-date the people who get all the credit. Conversely, some executives get fired before their legacy has come to light. The film executive Mark Canton was reportedly sacked by Columbia Pictures in 1996 for being “incapable of distinguishing the winners from the losers”. In reality, five huge hits (with combined box-office revenues of over $1.5bn) were in the pipeline. The assumption that success is inevitably caused by current senior management is misleading. Personally, when I am sceptical, I am more inclined to withhold a £30m cheque.

The American banker J P Morgan argued that a company’s top brass should never earn more than 20 times what those at the bottom do. Such a ratio now sounds laughably idealistic. In the first decade of this century, the average pay ratio of CEO to employee climbed from 47 to 128. This was not because they were doing a brilliant job. Even in downturns, top earners have continued to streak away from the field. Between 2000 and 2008, when the FTSE fell by 30 per cent, cash payments to executives increased by 80 per cent. It is not inevitable progress: it is fashion. At other moments in the history of business, the pie has been cut up differently. Between 1930 and 1960, the real income of top US managers fell. It is possible – as well as desirable – that inequality of income, now at an all-time high, could come back to more sensible levels.

As Ferdinand Mount pointed out in The New Few, his study of inequality, the galloping strides of today’s executive pay cannot be explained by supply and demand. Talent is always competing, whatever the era or arena. It is culture, not competition, that explains why pay gets out of hand. Recent studies of high pay explored how excessive rewards create a contagion effect. Boards of directors usually look at what other com­panies are paying, then set their own remuneration accordingly (Burberry’s outgoing chief executive, Angela Ahrendts, was poached by Apple for a £35m package). The researchers demonstrated that if 10 per cent of companies initially pay CEOs twice as much as competitors, compensation eventually doubles for all CEOs.

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Those defending Bailey’s proposed pay have typically used sporting analogies. Why shouldn’t business stars get paid the same as sports heroes? They argue that Bailey, who will remain chief creative officer as well as being chief executive, is both the CEO and the star player. What’s fair in sport, his apologists say, should be fair in fashion.

There are several problems with this argument. Even as an ex-sportsman, I’m far from convinced that top athletes deserve – or need – such outlandish rewards. I am also quite certain that if top footballers were paid half as much, the level of their game would not deteriorate at all. Beyond a certain level, money is a very weak source of inspiration. What motivates players to squeeze yet more cash out of their employers is pride or ego: it gives them a certain strut in the changing room. The money is just a number.

And there are more central problems with the sport-business analogy. If you are interested in the ways that sport is like life, then you must also be vigilant about the ways in which it isn’t. The level of transparency about how good you are is a perfect example of the latter. There can be no doubt about the achievements of a great athlete, especially in an individual sport. His or her career is revealed in its entirety on television for us to scrutinise and judge. How good is Novak Djokovic at tennis? There is no element of guesswork about the answer. We can be certain – more certain, surely, than we can be about the value added to a company by a business executive.

If Djokovic’s performances deteriorate, we will know about it as quickly as the Serb himself. Nor can he gain directly from any unearned and invisible inheritance from the previous Wimbledon champion. He has to win the prize money by explicitly defeating the competition – there are no cosy stock options that, in good economic times, will float upwards on a rising tide that raises all ships. Djokovic’s situation is different from that of a CEO who may benefit from opaque factors influencing his “track record”. This total transparency sustains sport’s ruthlessness. There is no soft landing in sport: you lose, pack your bags and go home.

Christopher Bailey is probably very good at his job. That doesn’t mean he must therefore deserve £30m. 

Ed Smith’s latest book is “Luck: a Fresh Look at Fortune” (Bloomsbury, £8.99)