Tom Glocer Educates Us On Marx and Adam Smith

My reasons for shying away from this topic have been numerous. First, as the chief executive of a public company, I have been on the receiving end of a large amount of executive compensation, and therefore I have always believed that my thoughts on the subject would be viewed as inherently biased, and perhaps they are. Second, this issue has become so politicized, that the sensible among us don’t wish to raise their heads above the parapet, preferring to duck criticism, stay under the radar and continue to collect pay. Finally, while I believe that the free market allocates capital and labor more efficiently than any other system, I worry that many western economies are hollowing-out their middle classes through policies which are creating a richer and smaller super class and a poorer and larger underclass; a highly paid executive class only exacerbates this trend.

So with these caveats in mind, my central thesis is that attitudes on, or regulation of, executive pay are fundamentally political and not economic in nature, and while there is nothing wrong with having a political approach to compensation, few if any of the active voices on the subject admit that they oppose free market economics.

There is a market for executive talent just as there is a market for tomatoes or electricity. The market is less liquid and the supply seemingly less fungible, but there is a market price established nonetheless, and plenty of pay consultants willing to provide the data. While there is some valid criticism of the role of pay consultants and the board compensation committees they serve, most objections to executive compensation boil down to three factors: (i) the excess quantum of pay (e.g., bankers in general); (ii) the context in which the pay package is awarded (e.g., “payment for failure” or payment despite a government bailout) and (iii) the form of compensation (e.g., stock options vs. performance-restricted stock or “bonus” rather than base pay (really factors (i) and (ii)) masquerading as (iii)). I will address each of these more mechanical issues below; however, the core of the pay issue remains political for me ? and there is nothing wrong with that if declared openly and applied consistently.

Let us imagine that there is a well ordered democratic society which has elected to protect and grow its middle class by constraining the distribution of income, wealth and other resources among its citizens. And let us suppose further that in lawful democratic elections it has voted (directly or through the election of like-minded representatives) to limit the spread of income to a ratio 5 to 1 ? I.e., the most highly compensated worker may not earn more than five times the least compensated one. Let us also assume that we can solve or at least ignore the myriad problems of calculating this ratio (e.g., compensation in cash vs. difficult-to-value securities, full-time vs. part-time employment, etc.). Finally, let us make sure that these rules apply not just to managers in public companies, but to private companies, hedge funds and all other forms of collective enterprise, and that we tax the inheritance of all forms of wealth as well, at (say) 90%. Taken together, these measures would narrow the distribution of income and wealth in this society. Perhaps surprisingly, I support the right of any lawful democracy to choose such an honest and direct way to promote a more egalitarian society. Now a totally separate question in a world of free choice and labor mobility is whether I, Tom Glocer, would choose to live and work in this society, or move to another country where the free market for labor and capital was less constrained. It would, in fact, be an interesting socio-economic experiment to conduct. Would this 5-to-1 limited nation produce any less GDP or would its citizens have any lower standard of living over time? There is one such experiment underway in a very big laboratory – – China ? but they are going in the opposite direction (from communism to a more market-led economy) in an effort to stimulate sufficient growth to raise the living standards of their large population.

What I like about the foregoing example is that it lays bare the choice of income and wealth distribution as a legitimate political one, without resort to the sort of demagoguery we hear from our politicians such as “saving capitalism from itself” and other misguided pious phrases. The genius of the free market is not that every distribution it makes is a “fair” one, but that on balance it does make more “good” decisions (allocations of capital and labor) than “bad” ones. Let me be clear: I believe in free markets because I believe they create a bigger pie for society at large; however, I also believe that there is a role for government to tax the beneficiaries of these free markets to provide a social safety net for the poor, the elderly and the infirm, and to promote quality education which enables social mobility.

Now let me turn to the criticisms of executive compensation I listed above.

(I) The Quantum of Pay ? or just too much pay. I don’t really know how to react to this criticism other than the political choice I outline above, it is an inherently political and non-economic argument. How much is too much? I used a 5 to 1 ratio in my example above, but this is an arbitrary choice; it could be 7 or 10 to 1. If we believe in housing markets, commodities markets and stock markets, there is no inherent economic reason to object to the market for executive or other labor. I don’t like to pay more in the supermarket for tomatoes than the market price; I don’t want to overpay for executive talent either.

(ii) The Context of Pay ?payment for failure, etc. This again is a political consideration. The board of directors of a company sets a compensation policy in advance and negotiates to employ a given executive. Later on, the environment changes and raises questions about the “appropriateness” of the bargain struck. Should we honor the contract? I don’t see why not. There is a very current and voluble example in the UK. Stephen Hester was hired by the board of The Royal Bank of Scotland to turn around the bank after the UK government had to acquire a majority of the equity in the bank to prevent its failure. Hester was not employed by RBS prior to its bail-out and appears to being doing a good job fulfilling the mission he was hired to perform. Yet, the proposed payment of a sub ?1m bonus to Hester (in RBS stock no less) was the subject of a two week government and media attack, culminating in his waiver of the bonus. For this act of political fealty, we can assume Mr. Hester will receive the knighthood that his predecessor, Fred Goodwin, has had rescinded, but the whole episode smacks of scapegoatism and political theatre and is unlikely to motivate the next talented executive to take on such a difficult challenge.

(iii) The Form of Compensation — or we”ll tell you how. There are many examples of this. I will pick two. First, there has been a strong line of attack in the RBS – Hester debate in the UK, that a bonus should only be paid for truly extraordinary performance and that in all other cases of good or very good performance, only the basic salary and benefits should be paid. While this may be a straightforward definition of the word “bonus,” it does not fit the way in which banks all over the world have made their compensation a more variable expense, typically by paying a smaller portion of overall compensation in the form of fixed salary and the remainder (often a multiple of base pay) in the form of a year end lump sum or “bonus.” For a cyclical industry in which labor is the highest cost input, this is a sensible way to set pay. Moreover, now that many banks have been forced to raise base salaries and pay less in bonus, they will need to fire more staff rather than trim the bonus pool in down markets, and this appears to be taking place. There is a separate and valid criticism of bank bonus culture ? that it may have contributed to the financial crisis by encouraging excess risk taking; however, this can and is being addressed through mechanisms such as paying the bonus in the form of stock which needs to be held for several years, and contractual clawbacks to recoup payments if the accounting was manipulated. In either case, it is the Board acting through its remuneration or comp committee that should set the quantum and form of pay on the basis of a complete picture of the objectives of the bank, the market for executive talent and the potential risks and rewards associated with various forms of compensation.

Second, the corporate governance elite, a high political priesthood if there ever was one, has ordained that stock options are not to be included in executive comp packages unless subject to a special performance condition. First, let me be clear, that I do believe that outright stock grants should be subject to some performance condition other than just the executive remaining breathing at the stipulated vesting time, because this pay mechanism constitutes a transfer of shareholder value equal to the full price of the stock on the date of grant, plus, it is hoped, further appreciation. There are some exceptions when purely time-retricted stock are appropriate, but I will skip over them here to stick with the central argument concerning options. By standard definition, stock options only deliver value to the holder if the underlying common shares increase in value over the stated exercise price (typically the fair market value on the date of grant). Thus, there is a built-in performance condition in options ? namely , that the share price go up. This is generally thought to be a good thing; however, the corporate governance elite, not apparently believing that good management has anything to do with the movement of share price, now insists that an additional condition or trigger be met (e.g., that the Total Shareholder Return (capital gain and dividends) exceed some benchmark). While this appears innocent on its face, it can lead to perverse results. Let us imagine that the market for a given executive indicates that I should pay $1 million to hire her, and that I choose to allocate this sum $250k in salary; $250k in annual bonus; $250k in restricted stock (subject to a performance vesting condition such as ROIC or EPS growth) and $250k in stock options. If I am forced , by prevailing corporate governance norms to impose an additional performance condition on her options, standard Black-Scholes (or any other economically-sound) methodology tells me that the grant will now be worth less than $250k (because of the additional condition imposed) and I will now need to issue more pieces of paper (say $300k in nominal options) to deliver the same value to the employee. In my experience, this is a lose-lose?lose, as the employee is worse off (she values the options less because of the uncertainty associated with their vesting and the loss of the clear line of sight provided by the share price alone), the company is worse off (because of the complexity and cost of administration, as well as the productivity loss from a less well motivated executive) and the shareholders are worse off (because of the equity dilution necessitated by the additional options). When it comes to executive compensation, Einstein had it right: “Make everything as simple as possible, but no simpler.”

So, my core message is that restraining executive pay (or football star pay or actress pay, for that matter) is a perfectly sensible political decision for any democratic society to make, but don’t confuse it with sound market economics. Pay should be based on performance and its quantum and form should be left to the board of directors to determine based on market supply and demand and the goals and strategy of the enterprise. If you don’t trust the Board to exercise this core function, why trust them to spend shareholder money on large capital investments, acquisitions or marketing? Vote them out of office if you doubt their competence; don’t try to do their jobs for them one step removed.