Putting Executive Pay in Context

By David De Cremer

Before the financial crisis executive pay in the finance sector had skyrocketed; bonuses were no longer given to reward hard and successful work, but rather automatically – no matter what the employee performance was. Below David De Cremer discusses the state of executive pay now and whether organisations will curtail it because they have to or because they should do – ethically speaking.

In the aftermath of the financial crisis no topic has received more attention than the payment of bonuses. Suddenly the issue of money, and particularly excessive amounts of it, was put on the societal and political agenda and it hasn’t really left the public discussion arena since. Even today, executive pay is leading to heated debates and politicians do not shy away from being the moral authority in the game by making regular statements that although many of the reimbursement systems are not illegal they do suffer from a lack of integrity.

This brings back memories of the emotional response of the then UK Chancellor of the Exchequer, Alistair Darling, who announced that he wanted to impose a one-off tax on banks to ensure that some of the excessive bonus payments were directed back to the taxpayer. Since then banks have been focusing on ways to rethink their pay systems, reduce salaries and find alternative means of keeping the highly paid amongst them aboard. Of course, the issue of pay is not only an issue in the financial industry but also in any larger company where board members may ask for the extra million to make them stay and feel happy in what they are doing. In these firms, money as the primary motivator is as present as in the banking context.

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Selfish or Ethical Motivation?

The belief that high bonuses are necessary to recruit talent and actually should remain part of the salary package – even independent of performance – is still alive and kicking.

What all these firms and industries have in common, however, is that although the financial crisis put forward a strong signal that they have to rethink the way they reward people for the right and appropriate reasons, this is also an issue caused by pragmatic concerns – that is, large pay checks and bonus packages are simply not that affordable anymore.

Many banks, such as Barclays, BNP Paribas, Credit Suisse, HSBC, UBS, and Citigroup amongst others, are feeling the financial constraints that make it difficult to maintain an excessive pay system. There is a tension between changing the pay system because we know there is something inherently wrong with it (in terms of efficiency and morality), versus changing it because we simply cannot afford it. If the former motive dominates, chances are high that firms will modify pay systems because they want to and are in search of alternatives that will create more sustainable and value-driven work places. In other words, the financial crisis will have changed their mindset, which is a necessary determinant towards changing their organisational culture and habits. If the latter motive dominates, however, it is likely that their mindset will not have changed – rather, as the situation calls for changes that are not necessarily wanted, behavioural change will happen in order to survive.

The above observation aligns well with recent claims that on the surface things seem to have changed; firms put a lot of energy and effort into managing their reputation of building sustainable businesses by limiting the impact of excessive executive pay. However, below the surface the belief that high bonuses are necessary to recruit the talent and actually should remain part of the salary package – even independent of performance – is still alive and kicking. If this is the case, then it is still waiting to come out again as soon as the economic engine is started up. Some of my research actually supports how hard-wired this belief in bonuses is. In a survey addressing 15 bankers at the executive level, it was found that the bonus culture is, in a way, a kind of self-created myth.

In this survey, executives were asked how important they considered bonuses to be for their own work performance and motivation and how important it was (in their view) for the performance and motivation of other bankers. In line with a self-favouring account, these executives responded that the bonus package did not matter so much to them but they did believe it mattered a lot more for other bankers. These executives, who were involved in recruitment from time to time, reasoned that others in the financial industry want high bonuses and therefore they have to keep paying them. It is a belief that is difficult to root out despite the fact that, I will explain below, people do look for other kinds of value, even in their work life.

What made this research really interesting is that there was a second part to the survey. In this second part, these executives had to make a decision between two types of bankers to take care of their personal savings. Banker A was portrayed as a banker who considered money as the primary motive in his/her career, whereas Banker B was presented as someone who found joy in the content of his job and was motivated to provide good service to his/her customers. All respondents went for banker B. This result may seem surprising, taking into account the fact that in the first part of the survey they clearly preferred hiring the money-motivated banker, thus Banker A.

This self-created myth satisfies the need to be rewarded financially and in a way makes the purpose of a financial bonus as a reward for good performance redundant. The bonus or high executive pay simply needs to be included, otherwise the job is not worthwhile. The fact that this belief still seems to have survived, even after the financial crisis and all the emotional debates about the pay system, can be explained by human nature. In our daily decisions, we always have the tendency to go back to the situation as it was before a crisis broke out. We feel comfortable with the status-quo and major changes induced by a crisis feel threatening. In other words, what we have acquired we do not want to lose. The pain of losing something you feel entitled to is much stronger than the positive feeling of gaining something you didn’t have before.

Emotionally speaking, losses dominate gains. In that sense, discussions about executive pay are irrational by nature, because it is something we have to change to be sustainable. In other words, if we do decide to change it, it will be motivated primarily by the fact that we have to because it is not affordable anymore. What can we do to counteract these natural human tendencies? First, we need to create awareness about the biases that we suffer from in the area of financial compensations. Second, we need to recognise the role our corporate leadership can play in creating a culture that does not only manage in terms of financial value but creates more a sense of shared values that go beyond the financial nature.

 

Human Tendencies and Financial Pay

One human tendency that was especially dominant in the bonus culture that we witnessed was the sense of entitlement. Stories abound of banks hiring investment bankers with a salary package that included a guaranteed bonus for the next three years. The more pervasive this hiring strategy was the more accepted it became and after a while a bonus for the financial world was simply perceived to be salary – earned regardless of performance – rather than a financial incentive that needed to be earned and proven by high performance. The consequence of this is that, for example, an investment banker would reason that simply because of who he or she was – in terms of his/her position – he/she was entitled to earn more. In other words, what you do does not matter anymore; it is who you are that determines the pay you are entitled to.

Some of our research indeed has provided evidence that if you ask people to describe their position (in our case a lawyer) they rewarded themselves a higher pay compared to when other people were asked to describe what a lawyer does and subsequently the pay he/she would deserve. Describing a position more easily activates feelings of entitlement, whereas when people think about the work that is actually involved the sense of entitlement is lowered. This tendency to strengthen the relationship between high status jobs and feeling entitled to earn more is created quickly, and especially so in industries where status and money go hand in hand. Based on these findings it should be no surprise then that this entitlement bias is not so easy to kill in the financial industry.

People’s perceptions of fairness are another human tendency that can quickly influence satisfaction with pay or not. Intuitively, one would say that in the debate about executive pay and the bonus culture, fairness should hold the expectation that pay is accurate and appropriate in the context of one’s performances. How then can a sense of fairness lead to the excessive bonus culture we have witnessed in the past? The primary reason for this is that fairness is in the eye of the beholder. What is fair to one person may not be fair to another. Fairness, to a large extent, is determined by reference points you choose in your close environment. This implies that a board member will more quickly compare him/herself to another board member and not, for example, to a bus driver. Happiness can be determined by how you look at things, and the same is true for fairness. Investment bankers use the bonus of the other investment banker to decide whether they receive fair pay. In light of this tendency it can happen that a board member feels unhappy about his/her salary simply because board members in other competing companies receive higher rewards.

Both human tendencies thus include a way of modifying the feelings of entitlement and fairness that serve them but that at the same time can also make them unhappy, resulting in cultures where bonuses and executive pay always have to increase in order to keep the troops on board. For obvious reasons, such a management strategy is not sustainable financially speaking, but it also indicates that management has to do a better job to (a) define entitlements more in terms of what people need to do in their jobs, and (b) use reference points of comparison that do not easily lead to perceptions of unfairness but rather fairness. Of course, this kind of management requires a type of leadership that is focused on something more than simply creating financial value.

 

Leading the Culture Shift

Agile leadership, which is creative enough to connect people in pursuing shared value based on deeper human needs than only money, is needed.

Ever wondered why highly paid executives quit their jobs? If high executive pay were the only source of happiness and motivation, it would be a very strange decision to make. But because we are social beings, our motivation is influenced not only by financial value but also by more social needs. Currently, people in the US prefer to work for high-tech companies like Google more so than for the Wall Street firms. Wall Street has reacted to this practice and has noted that companies like Google pay equal or even higher salaries than they do, so in their view the only remedy is to increase the wages being paid out on Wall Street. Unfortunately, in terms of motivation, they miss out on an important insight. These high-tech companies in Silicon valley are not only characterised by high pay, but even more so by a creative culture that creates value in a different way. An open feedback culture where people feel they belong thus addresses deeper social human needs. In such a culture joint value is created and pursued. And it is exactly this kind of value that our corporate leaders need to pursue in their search for means to motivate people in the aftermath of a crisis. The financial crisis has changed things and we need to adjust to it. Agile leadership, which is creative enough to connect people in pursuing shared value based on deeper human needs than only money, is needed. In the long term it will be more sustainable and cost-effective.

To conclude, when it comes to putting executive pay in context we need to realise that if your corporate mission and resulting leadership only works by focusing on money as a primary motivator, then you will have a problem. Money itself is not a problem, but if the focus on management is only on monetary incentives what else is there to manage? Not much, it seems. Under those circumstances, our natural tendencies will evoke a very narrow focus on the money that is or is not on the table. It is not difficult to imagine that such corporate cultures leave little chance for sustainable management of a company’s resources – including employees as the most valuable resource – to be picked up and drive the firm’s success.

About the Author

IMG_2651-rgbDavid De Cremer is the KPMG chair in man-agement studies at the Cambridge Judge Business School, University of Cambridge, and a visiting professor at China Europe International Business School. In 2009-2010 he was elected the most influential economist in the Netherlands. His consultancy and research interests are leadership effectiveness, trust as a business asset, value-driven decision making, and management and innovation challenges in China.

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