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10 per cent pay rise? That’ll do nicely…

No Free Lunch

10 per cent pay rise? That’ll do nicely…

Well, they got their headlines. A recent High Pay Centre survey concluded that the average FTSE 100 chief executive received £5.48 million in 2015, up from £4.96 million in 2014. That’s a 10.5 per cent increase in just one year and, it says, there’s no end to the rise and rise of top pay, now 129 times larger than the average total pay of FTSE 100 employees. It also refers to Theresa May’s words when she became the country’s chief executive in July: “There is an irrational, unhealthy and growing gap between what these companies pay their workers and what they pay their bosses.”

So there’s a hundred purring fat cats, then, each lapping up a tenth more cream than they used to. Before we get too outraged, perhaps we should dig deeper. For that impression turns out to be far from reality.

 

Feline obesity

The survey compares pay in the current FTSE 100 with pay in the FTSE 100 of a year before. But that flatters the increase because seven constituents changed during 2015. By definition, higher performing companies (where performance-related pay might be expected to be higher) displaced lower performing ones (where pay might be expected to be lower). Take these out so that the comparison is like-for-like and on my calculations, the increase in pay shrinks to 3.5 per cent, a far cry from the headline 10.5 per cent. Then there’s the big beast: Sir Martin Sorrell’s whopping pay increase of £37 million – a special case, surely, so we ought also to exclude his pay to get to the underlying trend: do that and the remaining 92 chief executives experienced a… well, not a pay rise at all, but between them, a cut of 2 per cent.

What’s going on? To really understand this, we need to look at the trend in each company, but let’s focus on the 10 highest paid chief executives in 2015. Seven received increases, some staggeringly so, but three were actually paid less:

Company2015 Chief ExecutiveTotal pay 2015 (£000)Total pay 2014 (£000)Change
WPPSir Martin Sorrell70,41642,97864%
Berkeley GroupTony Pidgley23,2963,757520%
Reckitt BenckiserRakesh Kapoor23,19011,237106%
SkyJeremy Darroch16,8894,880246%
ShireFlemming Ornskov14,6382,806422%
BPBob Dudley13,2969,28943%
Relx (Reed Elsevier)Erik Engstrom10,86916,176-33%
PrudentialMike Wells10,03111,834-15%
SchrodersMichael Dobson8,9058,1559%
Lloyds Banking GroupAntónio Horta-Osório8,77311,544-24%

 

The absolute pay is high, whichever way you look at it, but against these increases, there’s a counterbalance. Within the cohort of 10 highest paid in the year before, three dropped out in 2015 due to pay cuts of about 80 per cent:

Company2015 Chief ExecutiveTotal pay 2015 (£000)Total pay 2014 (£000)Change
ExperianBrian Cassin1,9479,868-80%
Hargreaves LansdownIan Gorham1,91010,608-82%
Royal Dutch ShellBen van Beuren4,04919,510-79%

 

Strip all these double-digit variations out of the mix, and the 2015 pay received by the remaining 85 averaged £4.18 million each. We’re back in positive territory: that’s an increase of 6 per cent from an average £3.94 million in 2014. We could go on. Several FTSE 100 companies conduct some or most of their business outside the UK; and several chief executives are based abroad and are paid in foreign currencies – should these be excluded too if the purpose of the survey is to draw conclusions about pay in the UK? In fairness, the High Pay Centre acknowledges several caveats about its survey: some companies replace their chief executive during the year; financial year-ends differ between companies; foreign currency translations can vary; and companies report aspects of pay in different ways.

 

Lumpy pay

What’s striking is that there is no uniform trend. In the pay stakes, some chief executives gain, some lose; winners one year can be losers the next. In fact, looked at together, their pay resembles a random walk, something familiar to anyone who invests in shares or funds: their diverse pay rises and falls have similar characteristics to price movements in a portfolio of shares.

That’s hardly surprising. Chief executives receive a core of fixed (or guaranteed) pay, similar to other employees. But typically three quarters or more of their pay is at risk: awards of potential shares that depend on their future performance. These awards have potential values of several times their salary. If executives underperform, they get nothing. If they drive their company to a strong performance, there’s the double whammy of a high payout of shares boosted by an increased share price. The resulting lumpy pattern of feast and famine could be interpreted not as irrational, but as confirmation that performance targets have been suitably challenging.

At Berkeley, Mr Pidgeley had to wait until 2014/15 to exercise share options originally granted six years earlier when stock markets were close to bottom. He exercised few if any in 2013/14. Between the grant and the exercise, Berkeley’s share price went up sevenfold, though it has since fallen back.

As Stefan Stern, director of the High Pay Centre, told the Radio 4 Today programme: “These very big numbers come out at the end of these so-called long term incentive plan contracts which shareholders vote and approve - and then out comes a big number at the end and people get upset. It’s as though they have not really understood the quantities that are going to get paid out at the end of some of these contracts.” True, but investors can’t predict what their shares will be worth in a few years time either and they want the pay of those running the business to be in step with their gains or losses.

Share awards are the main reason for pay volatility, but there are others. At Shell, only a sixth of Mr van Beurden’s share award vested in 2015 but his apparent pay fell because when he became chief executive in 2014, he started being paid in the UK. UK accounting rules had to be applied to his past salary-linked pension and Shell paid some of his personal tax to avoid him being worse off by moving here. These fell out of the 2015 figures, resulting in the apparent cut. At BP, part of Mr Dudley’s 2015 increase was also due to a UK pension valuation which, BP notes, is arbitrary and a third higher than how US accounting rules value such pensions.

 

Flaky employees

Trying to work out the total pay of company employees is not easy either. The High Pay Centre complains about inconsistent disclosure: some companies publish data that excludes bonuses and cash incentives; some also exclude pension and share-based pay. The true value of all-employee share plans, which enable employees to profit from the same increasing share price that boosts the pay of their chief executive, is overlooked as well.

Another question is: how meaningful is it to lump together diverse cohorts of employees of varying levels within the organisation? A lower ratio could be due to management becoming top heavy rather than more pay going to the lower paid. More fundamentally, are these employees just in the UK or across several countries where, of course, local rates of pay can be very different?

So that 1:129 ratio is rather flaky. According to the Office for National Statistics, in general, UK wages have grown by around 1.5 per cent a year between 2009 and 2015. But that underestimates take-home pay. Over this period, for those on the national average, higher tax thresholds will have increased net pay by another 0.5 per cent a year; and cuts in mortgage rates could have added another 5 per cent a year to residual pay. In worrying about the pay gap, it’s too easy to focus on near-static gross pay, and gloss over Government initiatives that have made many better off.

So what of Mrs May’s assertions? Is the pay gap irrational? Volatile, certainly, but that’s the market for you. Unhealthy? Many think it is, even if it might be overstated, but that begs the question of how wide it should be. Growing? In some companies, yes; but not in others.

The High Pay Centre supports Mrs May’s preference for exerting more control by giving employees a say on executive pay and for annual binding shareholder votes. Others fear this would be impractical. A simpler solution might be for companies to place a ceiling on the future value of long-term pay for chief executives at the time that awards are made.

 

Unintended consequences

Pay is an emotive issue and perceived pay inequality is more than just a concern. Mrs May is well aware that it was an ingredient of the protest vote that swung the referendum marginally in favour of Brexit (and led to her appointment). The dilemma faced by a Government struggling to limit the economic fallout following the vote, and which takes 60 per cent (in income tax and national insurance) of high pay in the UK, is that if they do anything that overlooks the cross-border nature of many FTSE 100 companies, more business activity could drift away from the country.

Anyone paid in foreign currency is now earning far more in sterling terms, thanks to the post-referendum diminished pound. The other impact of the Brexit vote is that companies with predominantly foreign earnings have seen their share prices surge. This will in turn boost the value of share awards that mature in 2016.

So expect higher average chief executive pay in next year’s survey. That might not have been what the Government (nor the referendum protest voters) intended, but that’s what is likely to be achieved.

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