Bonus culture will hurt UK in the long-term

Anthony Hilton
The London Evening Standard, 10th May 2016

It is interesting, if depressing, to note how much profit growth at the typical British quoted company over the past decade can be attributed to cost-cutting rather than to investment to expand the business and how this is storing up problems for the future.

We cannot pay our way in the world as it is, with today’s trade balance worse than at any time since 1948. The weaker our companies become, the less likely it is that we will be able to fare any better in the future.

The cost-cutting takes many forms but has at least two consequences. First, employees today get a much worse deal than they used to and this is in spite of the fact that every annual report contains a paragraph from the chairman saying how valued the work force is.

The wholesale closing of final-salary pension schemes amounts to a truly massive pay cut for all concerned, and goes some way to explain why the share of profits in national income is way above the long-term trend while labour’s share is proportionately diminished.

It also in part explains why trust in business is low — people feel alienated from the system, and so many people need two jobs to get by.

Less visible and probably less obvious is the diminished resilience of firms — something which has had interesting consequences in the insurance industry. As each company reduces costs — for example, by cutting the number of call centres from three to one, halving the number of maintenance staff, or extending the life of equipment, streamlining the supply chain, or stripping out anything which could remotely be described as fat — margins appear at first to improve, giving the chief executive what he desires to satisfy the City.

But this too often comes at a cost which is apparent only after the relevant chief has collected his performance bonus and moved on.

Almost every round of cost-cutting makes a business less resilient to setbacks, so that when the unexpected does arise, the effects are far more damaging.

For signs of this it is instructive to look into the reasons why insurers such as Zurich, one of the main carriers of business risk, is having such a hard time. It is experiencing far greater losses than it had come to expect from relatively conventional lines of business.

One reason for this, according to an expert in the field — if you prefer, a mole — is that its business clients are hollowed out and fragile in a way they never were before, so any hit they receive becomes far more costly than similar problems had been in the past. This in turn leads to Zurich being hit with a much bigger bill for business interruption or whatever its specific exposure is.

Meanwhile, company executives have never had it so good. Their salaries have soared so much that even the leaders of the fund-management industry are going public with their concerns. This is in itself a remarkable development. Fund managers are not exactly underpaid themselves. If even they think executive pay is over the top you can be sure it is.

To judge from how it has been reported they have two concerns. The primary one is that executive pay has virtually trebled in the past decade while share prices have barely moved so they wonder what they have been paying for; second, the more socially aware among them worry that the unfairness of the system is destroying public trust in business.

But this isn’t the only reason to be worried. According to work done by economist Andrew Smithers, and published most recently in an article in World Economics, poorly designed managerial incentives have a poisonous effect on executive behaviour and economic performance.

His conclusions, backed up by detailed statistical analysis going back over many years, run as follows:

First, managerial incentive systems which are heavily focused on bonuses increase inequality while lowering investment in the business, undermining work ethics and doing damage overall to welfare.

Second, the economic slowdown in many of the world’s leading economies is not the inevitable aftermath of the financial crisis as many choose to believe. Instead it is the result of demographic changes — the growing proportion of retired people coupled with a slump in productivity which is the measure of value added per hour worked. The slump in productivity can only be reversed by a major increase in investment.

Third, modern management remuneration systems provide strong incentives to change short-term corporate behaviour in ways that are not in the long-term interests of the economy. In particular, the desire to hit a bonus target encourages aggressive pricing as a device to maintain or enhance short-term profits and discourages investment and measures to improve productivity because in the short term these may hit profits.

Fourth, Smithers says that recognising this problem — understanding how the bonus culture is part of the problem facing Britain, not part of the solution — is an essential first step towards sorting things out and putting in place policies which will stimulate genuine and sustainable growth. If bonuses have to be kept then they need to be much better crafted and linked almost exclusively to measured improvements in productivity. At the same time the Government should create tax incentives to reinforce positive changes in behaviour and penalise those who are slow to change.

Smithers has been arguing this case for some time now without getting the support he deserves. But if investors are now genuine in their concern for what is happening in the realm of executive pay, his arguments give them every reason not to give up until they achieve meaningful change.