If You’re So Ethical, Why Are You So Highly Paid?

Front matter

Alexander Pepper

If You re So

Why Are You So

Contents

Extended contents Preface Acknowledgements About the author List of figures Glossary 1. Introduction - ethics, inequality and executive pay 2. Executive pay and distributive justice 3. What do business executives think about distributive justice? 4. Welfare liberals 5. Relational egalitarians 6. Meritocrats 7. Free marketeers 8. If executives are so ethical, why are they so highly paid? 9. What is to be done? 10. Afterword and postscript Appendix: Background survey research for this book Notes

References viii

Extended contents

Preface

One of my friends, lets call her ‘Mrs Taylor; used to run the elementary department of an independent boys’ school in the south of England. She is an enlightened teacher and, as well as ensuring that her pupils had a good grounding in English, maths and science, she also ran a lunchtime philosophy club to introduce year 1 and year 2 boys (aged between five and seven) to, as she used to describe it, the ‘joys of philosophising’ Each week they would discuss knotty dilemmas such as the pros and cons of factory farming, the significance of names, and the problems of perception (why do our eyes sometimes deceive us?). As is often the case with philosophy, the boys learnt that there is typically no single right answer to a philosophical question, just a set of better or worse possible responses and a clearer understanding of the problem. One day Mrs Taylor presented her class with the following scenario. ‘Imagine, she said, ‘that we are a band of pirates. By our efforts we have recently uncovered an enormous stash of treasure. After celebrating our find, we now have to decide how we are going to share out the treasure. I am the leader of the pirate band, so I will get half the cash. You have to decide how to share the other half out among yourselves: The boys discussed a number of options, perhaps sharing out the treasure in proportion to their ages, how good they were at football, or based on their academic ability. After some discussion they decided to share the treasure viii If You're So Ethical, Why Are You So Highly Paid?

equally - the egalitarian option. This seemed to be a satisfactory conclusion, but there was one thing that still troubled one member of the class. Excuse me, Mrs Taylor; said one little boy cautiously, ‘why is it that you get half the treasure?’

‘Why does Mrs Taylor get half the treasure?’ or ‘Is it fair that some people appear to obtain a disproportionate share of income and wealth?’ has become one of the defining issues of our age. The particular focus of this book is on business executives, the people Thomas Piketty in Capital in the Twenty-First Century describes as ‘super-managers.' It is a book about distributive justice, about how the benefits and burdens of economic activity are shared out among individuals in society. More prosaically, therefore, the ‘Mrs Taylor’ question might be restated as follows:

Is it right in terms of distributive justice that super-managers appear to be able to capture such a large share of the value created by the companies that they manage?

Everyone seems to have a view about this question. The leftleaning High Pay Centre asks whether it is right that by the third or fourth working day of the year the average chief executive of a FTSE 100 company will earn as much as the average UK worker will earn in a year. The right-leaning Adam Smith Institute has argued that outrage over executive pay is over-egged, and that the falling pay gap between FTSE 100 CEOs and their employees in 2020 and 2021, largely driven by challenging economic circumstances during the worst months of the COVID-19 pandemic, was nothing to celebrate - it did not help the economy or make the average worker any richer.’ The Investment Association, the trade body and industry voice for UK investment managers, has called for companies to be sensitive to the experiences of employees and customers when deciding on executive

Preface ix pay and bonuses.‘ The Archbishop of Canterbury, Justin Welby, has warned that Britain faces a ‘crisis of capitalism, citing growing public anger about excessive executive pay and arguing that our ‘form of capitalism has lost any contact with a moral foundation" However, what nobody has done before is to explore what business executives themselves think about distributive justice. How do their personal beliefs about justice and fairness fit with high rates of executive pay? Are top executives really the greedy ethical egoists of popular culture, or do they share wider society’s concerns about large pay differentials and high levels of inequality? If so, how do they reconcile their ethical beliefs with high pay? These are the kinds of questions that I have set out to explore in this book.

The purpose of this book

I have been thinking about senior executive pay for over 30 years. From 1990 to 2008 as a partner at PwC I advised companies on tax and executive compensation. For the last 14 years as an academic at LSE I have taught a course on strategic reward and carried out research on the pay and motivation of senior executives. In academic terms I am something of a magpie - I like collecting and reassembling diverse ideas from different academic disciplines. I was educated first as a philosopher, then (because the careers service at my first university pointed out that there were very few jobs for philosophers) as an accountant, and most recently as a management scholar (itself, at least in my case, an eclectic mix of new institutional economics, organisational behaviour and economic psychology). Part of the attraction of studying executive pay is that it has allowed me to dabble in economics, psychology, law, accounting and most recently business ethics. Politically x If You're So Ethical, Why Are You So Highly Paid?

I am a socially inclined (modern; ‘Americar’ or ‘left, depending on your choice of terminology) liberal. My intellectual heroes include Thomas Jefferson, John Dewey, John Maynard Keynes, Karl Popper and John Rawls. I believe in free markets, free trade, individual rights, capitalism, democracy and internationalism, but also in equal opportunities, equality before the law, and social justice - I am committed to the idea that everybody has the right to lead a dignified life. I have been concerned for some time about inflation in executive pay, which I believe is a problem for a number of reasons. First, executives may be extracting economic rents (that is, amounts exceeding that which is economically or socially necessary) to the detriment of shareholders and other stakeholders who have a legitimate interest in the financial performance of companies. If so, this is inefficient and results in suboptimal economic outcomes. Second, differential rates of pay inflation in the last 30 years (high rates of pay inflation for executives compared with moderate rates for others) have contributed to rising levels of inequality - this is Thomas Piketty’s argument, which I consider in Chapter 1. Third, high executive pay has resulted in public outrage that, if unchecked, might lead in the course of time to social unrest. Each one of these is sufficient cause for governments, investors and executives to be concerned.

My main objective in writing this book is to try to extend the debate about executive pay — to move it on from the economics and public outrage which seems to characterise much of the current debate — by introducing a philosophical perspective and some ethical terminology. Although it draws on academic research, in particular a paper entitled “What Do Business Executives Think about Distributive Justice’ which was first published in the Journal of Business Ethics in September 2020,° it is intended for the widest audience possible, including business executives, inves-

Preface xi tors, policymakers, and the public generally. For this reason, all references have been confined to endnotes. I hope the book will also be of interest to academics in the disciplines of philosophy and economics, as well as social scientists who have an interest in the topicalissue of high pay. Readers in the policy area will find the arguments relevant, particularly given the fact that high levels of executive pay are a frequent source of public concern and political debate.

Finally, readers who are familiar with the literature on distributive justice will recognise that If Yowre So Ethical, Why Are You So Highly Paid? is a riff on the title of a book by the Oxford philosopher G.A. Cohen, If Youre an Egalitarian, How Come You're So Rich? I hope if he were still alive to read this that he would not be offended.

—Alexander Pepper Guildford, May 2022

Acknowledgements

I owe particular thanks to my research collaborators on the project which lies behind this book, Dr Susanne Burri, who taught me about distributive justice, and Dr Daniela Lup, who helped with the statistics. The appendix to the book draws on published joint work with them. Adam Bassett, Jason Buwanabala, Tom Gosling and Simon Hunt of PwC also played significant roles in the original research.

My thanks are also due to a number of ‘critical friends’ who have read and commented on various drafts of the manuscript. These include my colleague Rebecca Campbell, Stefan Stern, formerly director of the High Pay Centre, Alistair Pepper (the family economist) and Robert Pepper (the family philosopher). Simon Pepper gave advice on the title. Particular thanks are due to Dr Susanne Burri and Professor Paul Willman, who both made some especially insightful suggestions on the main text. A number of anonymous reviewers have also generously given up their time to read and comment on the manuscript. If I have forgotten anyone, I hope they will forgive me. All errors or omissions of course remain my own.

About the author

Alexander (‘Sandy’) Pepper is Emeritus Professor of Management Practice at the London School of Economics and Political Science, where he has been teaching and researching since 2008. Prior to this he had a long career at PricewaterhouseCoopers, where he held various senior management positions, including as global leader of PwC’s Human Resource Services consulting practice from 2002 to 2006. His research and teaching interests include organisations and management theory, with a particular focus on the theory of the firm, corporate governance, and business ethics. Sandy is one of the UK’s recognised experts on executive pay. He is the author of several academic articles and books on the subject,including Agency Theory and Executive Pay (2019), The Economic Psychology of Incentives (2015) and Senior Executive Reward - Key Models and Practices (2006), as well as numerous blogposts and newspaper articles.

1.1 1.2

8.3 9.1 9.2

9.3

List of figures

Income inequality in the US and UK, 1920-2020

Ratio of CEO total earnings to employee average earnings, 1965-2020

The knowledge-beliefs—behaviours nexus

The remuneration committee's dilemma

Six principles of distributive justice

Four clusters of respondents’ attitudes

How the four clusters draw on the six principles Cohen’ analysis of the difference principle Traditional pay versus new pay

David Miller’s pluralistic view of distributive justice GDP per capita in the US and UK, 1700-2000

The LTIP (long-term incentive plan) value gap

Comparing the performance of long-term incentive plans (LTIPs) versus restricted stock awards (RSAs)

Solutions to the remuneration committee’s dilemma Key issues in ESG (governance) investing

FTSE 100 CEO and other director total earnings, 2000-2020

Aristotle’s conception of virtue xviii If You're So Ethical, Why Are You So Highly Paid?

A.1 The gender and age of respondents 141 A.2 The companies, job titles and salaries of respondents 141 A.3 The industry sector of respondents 142 A. The country of respondents 143

A.5 How respondents were distributed across four clusters 146 A.6 Cluster analysis scores for the principles in each cluster 147

A.7 Comparing cluster demographics using chi-square scores 149

Glossary

While this book is intended to be non-technical and for a wide audience, some economic and philosophical terminology has inevitably crept in. As far as possible, I have explained any technical terms I have used as part of the main narrative. For convenience, I also include a short summary here.

Desert: This is an important concept in ethics and the theory of justice; it means what is deserved, taking into account all relevant principles of justice and fairness. Desert requires each person to be provided with benefits and burdens proportionately, taking into account their relative contribution.

Distributive justice: One aspect of the philosophical theory of justice is how economic goods (see the separate definition below) should be distributed in society. Distributive justice focuses on securing just or fair outcomes. This is sometimes contrasted with procedural justice, which focuses on the processes and procedures whereby particular outcomes are determined.

Efficiency: Efficiency is a foundational concept in economics. An economically efficient outcome is one where inputs are minimised for a given level of outputs, or outputs are maximised for a given level of inputs. “Pareto efficiency, named after the Italian economist and philosopher Vilfredo Pareto, provides that an outcome is efficient only if no one can be made better off without making somebody else worse off.

Egalitarianism: An ethical perspective that emphasises the desirability of economic, political and social equality.

XX

If You're So Ethical, Why Are You So Highly Paid?

Egalitarians prioritise equality for all people and take it as axiomatic that all humans are equal in fundamental worth or moral status.

Epistemology: The branch of philosophy that enquires into the nature and grounds of knowledge. Epistemology addresses fundamental questions such as “what can we know? and ‘how do we know it?’

ESG investing: An investment approach that involves the consideration of environmental, social and governance factors alongside financial measures in the investment decision-making process.

Good: In economics, a good is a noun meaning a thing of value -

“any physical object, natural or manmade, or service rendered, that could command a price in a market: In ethics, on the other hand, the good is a normative concept, meaning ‘that which conforms to the moral ideal. For example, Plato defines ‘the good’ in his theory of forms as ‘a perfect, eternal, and changeless entity existing outside space and time, in which particular good things share. The philosopher John Rawls also talks about ‘social goods; such as freedom and equal opportunities, which he saw as more fundamental to leading a good life.

Isomorphism: In sociology, isomorphism describes a process whereby social practices or entities come to develop similar structures or forms. Sociologists distinguish between mimetic isomorphism (copying or imitation), coercive isomorphism (for example, complying with a mandated rule), and normative isomorphism (such as following ‘best practice’).

Long-term incentive plan (LTIP): Also known as an ‘LTIPs, long-term incentive plans involve contingent awards of deferred shares that vest over time (normally at least three years) provided that demanding performance conditions, typically relating to financial performance, are met. LTIP awards are normally only made to very senior executives and are dependent on their continuing employment. LTIPs are

Glossary xxi intended to align the interests of top managers with those of shareholders.

Maximin: In game theory, maximin is the strategy that seeks to maximise the minimum possible payoff of any player in the game. In the hands of the philosopher John Rawls, the maximin strategy becomes a principle of justice that he calls ‘the difference principle. This requires that any inequality in society should only permitted if, in the long-run, it benefits the least well-off member of that society.

Prisoner’s dilemma: A foundational concept in the economic theory of games, describing a situation in which it pays two or more individuals to behave in a particular, suboptimal way, even though it would benefit them collectively to act in a different way.

PwC: PricewaterhouseCoopers, one of the ‘big four’ global accounting firms.

Rent: Economic rents are payments made to a factor of production (land, labour or capital) in excess of that which is necessary to bring that factor into production, for example a scarcity rent for goods in short supply.

Restricted stock award (RSA): An award of shares with a timebase vesting schedule, typically of at least five years. Restricted stock awards are much simpler than LTIPs, and do not include performance conditions, but may require shares to be held for a further period after vesting.

Stocks and flows: Economists distinguish between the stock of goods measured at a particular point in time, and the flow of goods measured over a period of time. Thus, wealth is a stock, while income is a flow.

Sufficientarianism: The ethical perspective that all members of society should have an income that is sufficiently high to lead a dignified life, and that this is the only principle of distributive justice that matters.

xxii If You're So Ethical, Why Are You So Highly Paid?

Thought experiment: Philosophers sometimes use thought experiments - imagined, extreme, hypothetical situations, which often appear to be somewhat detached from reality - to test, from first principles, their ideas, concepts, theories and ethical doctrines.

Welfare: An important concept in economics and ethics, welfare is an assessment of the wealth, health, happiness and general well-being of any individual or group of people.

Value: In economics, value means something of worth. This is sometimes further subdivided into either ‘value in use, being the pleasure or welfare that a commodity generates for its owner, or ‘value in exchange, being the quantity of other commodities (or more usually money) for which something can be exchanged. In ethics, value(s), more often discussed in the plural, are the basic and fundamental beliefs that guide or motivate attitudes or actions. Values help to determine what is important to us. They are personal qualities that we choose to embody to guide our actions.

CHAPTER |

To study a corporation may be economics, or sociology, or law; to study its activities as resulting from the purposes of persons or as affecting the welfare of persons, and to judge its acts as good or bad from such a point of view, is ethics.

John Dewey and James Hayden Tufts (1908)’

Why do some people appear to obtain a disproportionate share of income and wealth? The French economist Thomas Piketty, in his book Capital in the Twenty-First Century, frames the problem in a rather old-fashioned way as a tussle between capital and labour. His main thesis is that inequality is rising because the rate of return on capital, held disproportionately by the wealthy, exceeds the rate of growth of output and income. It did this at the end

Pepper, A. 2022. If Youre So Ethical, Why Are You So Highly Paid? Ethics, Inequality and Executive Pay. London: LSE Press. Pp. 1-17. DOL: https://doi.org/10.31389/lsepress/eth License: CC BY-NC of the 19th century and is doing it again at the beginning of the 21st. As a result, according to Piketty, ‘capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based: This is, he believes, a most serious matter. It is hard to think otherwise.

A brief history of inequality in the 20th century

Inequality can be measured in a number of different ways, depending on whether the focus is on wealth, savings or income. Income inequality is illustrated by charting the top 1 per cent of the population’s share of total income. For Anglo-Saxon countries such as the US and UK, over the course of the 20th century this distribution shows a distinct “U” shape: the level of inequality was very high at the start of the century and fell to much more moderate levels in the 1970s, before rising again in the 1990s and at the start of the 21st century.’

The end of the 19th century in the US is described by historians as ‘the Gilded Age’ a satirical reference, after Mark Twain's book of the same name, to the gilding of economic success that benefitted one section of the population but which masked widespread deprivation affecting other parts of the population. For sociologists of the period it was a pejorative term describing a time of materialistic excess combined with extreme poverty.” The journalist and historian Simon Heffer has described the corresponding period in Britain as “The Age of Decadence:!! On the European continent it is known as ‘La Belle Epoque’ (‘the beautiful era’).'”

The Gilded Age gave way to the ‘Progressive Era in the early 1920s, when Presidents Theodore Roosevelt, William H. Taft and Woodrow Wilson, supported by investigative journalists such as Ida Tarbell and progressive lawyers like Louis Brandeis, challenged the industrial ‘trusts’ created by wealthy and powerful businessmen like Cornelius Vanderbilt, John D. Rockefeller and Andrew Carnegie, who established monopolies over railroads, oil refining and steel production, aided by financiers such as J.P. Morgan and Andrew Mellon. At the same time, social reformers like Jane Addams lobbied hard to improve the conditions of the working classes and to reduce poverty.

Despite the best efforts of the progressive movement, by 1920, towards the end of Woodrow Wilsons presidency, the top 1 per cent still earned around 19 per cent of total income. However, as a result of continuing social reform in the US, Franklin D. Roosevelt's New Deal Coalition, which defined modern liberalism throughout the middle third of the 20th century, as well as the rise of the Labour Party in the UK and the great economic levelling effect of the Second World War, by 1975 this had reduced to 10 per cent in the US and 7 per cent in the UK.

Changes in governments and new economic policies, especially ‘Reaganism in the US and “Thatcherism in the UK, meant that the top 1 per cent’s share of total income began to rise again in the mid-1980s. By the beginning of the 1990s some commentators were talking about the start of a “Second Gilded Age. Others trace the origins of the new era back to Milton Friedman's contention in the New York Times in 1970 that ‘the social responsibility of business is to increase its profits.'* This was followed in 1976 by a much-cited paper entitled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’ by economists Michael Jensen and William Meckling, who described corporations as ‘legal fictions which serve as a nexus for a set of contracting relationships among individuals’ and provided support for linking executive pay to rises in company share prices." These intellectual foundations were followed in turn by the demerger movement of the 1980s, when investment banks took apart many large conglomerates in the US and UK, arguing - often, it has to be said, with some justification — that the sum of the parts was greater than the whole. What finance scholars have described as the ‘market for corporate control’ (meaning that underperforming management teams could be replaced) forced companies to restructure en masse, with waves of redundancies and outsourcing that left the corporate sector ‘lean, mean, and focused on its core competencies. Sociologist Greta Krippner describes this whole process as ‘the financialization of the economy. As another sociologist, Jerry Davis, puts it, ‘[t]he corporation has increasingly become the financially-oriented nexus described by its theorists:!°

As is clear from the above, neither Krippner nor Davis is a fan of financialisation. The merits or otherwise of the fundamental shift in industrial and economic policies that began with the Reagan and Thatcher governments in the 1980s are not really the subject of this book. It must also be remembered that the 1970s, when inequality was least pronounced, was a traumatic economic decade in the US and the UK, with low growth, high unemployment, high inflation, and poor returns for investors. Nevertheless, one of the consequences of financialisation is that by 2020 the top 1 per cent’s share of total income had again reached 19 per cent in the US and 13 per cent in the UK, as shown in Figure 1.1.

Lest this be thought solely an Anglo-Saxon phenomenon, at the start of the 20th century the levels of inequality in Germany and France were similar to those found in the US and UK. In 1920 the top 1 per cent earned 22 per cent of total income in Germany and 18 per cent in France. By 1975 this had reduced to 10 per cent in Germany and 8 per cent in France. The rise in the top 1 per cent’s

Figure 1.1: Income inequality in the US and UK, 1920-2020

25% 20% 15%

Top one per cent share of total income

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US ---- UK share since then has been less steep than in Anglo-Saxon countries, and by 2020 had reached 13 per cent in Germany and 10 per cent in France. In Sweden the top 1 per cent earned 22 per cent of total income in 1920, 9 per cent in 1975 and 10 per cent in 2020. Even communist China, with its distinctive political and economic systems, saw the top 1 per cent’s share of total income rise steadily from around 6 per cent in the 1970s to nearly 14 per cent by 2020.

The rise of the super-manager

In explaining the rise in income inequality in the latter part of the 20th century and beginning of the 21st, Piketty draws particular attention to the increasing inequality of labour income, which he attributes to two things - the growing wage gap between college graduates and school leavers, and the rise of the very highly

Figure 1.2: Ratio of CEO total earnings to employee average earnings, 1965-2020

CEO to employee earnings ratio

Fortune 350 paid ‘super-manager. Nobel Prize-winning economist Robert Solow writes that ‘it is pretty clear that the class of super-managers belongs socially and politically with the rentiers:"” This is a reference to ‘rentier capitalism, structured around the exploitation of financial capital and other scarce assets at the expense of wage earners. It is the rise of the highly paid super-manager and the question of distributive justice that is my primary concern in this book.

Figure 1.2 charts the ratio of median CEO total earnings to all-employee average earnings for the period 1965-2020 for FTSE 100 companies in the UK and Fortune 350 companies in the US. At the start of the period the ratio of median total pay of FTSE 100 CEOs to UK average national private sector earnings was 22:1 and the ratio of Fortune 350 CEOs to US typical worker earnings was almost the same, at 21:1. In the US the ratio peaked in 2000 at 366:1, falling to 213:1 in 2010 after the global financial crisis, before rising again to 320:1 by 2020. In the UK the ratio peaked in 2015 at 163:1 and appeared to be stabilising at around 135:1, before declining steeply to 95:1 in 2020 during the COVID-19 pandemic, when executive pay fell sharply. In 2020 median FTSE 100 CEO pay amounted to £2.7 million, compared with UK average national private sector earnings of just over £28,000, though most commentators attribute the fall from the 2019 level of £3.25 million to financial constraints imposed as a result of the economic consequences of the pandemic. Fortune 350 CEO median pay was $20 million in 2020, compared with a typical workers earnings in the US of around $65,000.!°

CEO compensation and the ratio of CEO pay to average earnings in Germany tends to be lower than in the UK, and is lower still in Sweden, but data for France are broadly comparable to the UK. German companies tend to pay higher salaries than in the UK or France, but deliver smaller amounts in the form of stock-based pay. All these countries have seen significant rates of growth in executive pay between 2000 and 2020.”

‘Super-managers’ are the focus of this book, and the question that I pose is an ethical one: is it right in terms of distributive justice that super-managers appear to be able to capture such a large share of the value created by the companies which they manage?

Ethical enquiry

Academics can at times be extraordinarily tribal. Each discipline and sub-discipline has its own journals, favours different research methodologies, and prefers to attend conferences with other practitioners of the same discipline. In 1973 the economist Axel Leijonhufvud wrote a delightful satirical essay entitled “Life Among the

Econ; describing the economics profession as through the eyes of an imaginary anthropologist observing a tribal community ‘in the far North. He notes that the Econ tribe was marked by clannishness and xenophobia, with particular ‘distrust and contempt’ for the ‘Polscis’ and ‘Sociogs.” Nor are political scientists (Polscis) or sociologists (Sociogs) exempt from this kind of tribalism.

While economists, political scientists, sociologists, jurists and management scholars have all written extensively about executive compensation and inequality, they have tended to talk among themselves rather than to each other. In this book I draw on research from across the social sciences, but do so from a perspective strongly influenced by my original training as a philosopher, on the grounds that, as the quotation from Dewey and Tufts at the beginning of this chapter makes clear, the actions of persons associated with corporations, and whether they are to be judged good or bad, is ultimately a matter of ethics.

This book crosses traditional boundaries in another respect as well. Until recently philosophers have eschewed empirical work, preferring rational analysis, dialogue in seminars and at conferences with other philosophers, and thought experiments. Social scientists favour an empirical approach, using surveys, field observation and experiments in behavioural laboratories to gather information, before analysing the data using statistical techniques. This study combines both approaches.

One of the most famous philosophical thought experiments is the so-called ‘trolley problem. Imagine a scenario in which a runaway train is hurtling down a hill towards a group of children who are playing on the track below a railway bridge. Is it permissible to push a grown man off the bridge in order to stop the train and save the children if no other options are available? Many books and academic papers have been written on this subject.” Thought experiments are used to place logic and reason at the heart of ethical decision-making. They are used to test the validity of ethical principles in particularly tricky cases (does the application of a specific principle make intuitive sense?) as well as to test the ethical relevance of particular features of a case (what happens when one feature is varied while others are held constant?). Many philosophers think thought experiments are of critical importance in developing robust ethical understanding.”