"Nothing sinks so gently and deeply into men's minds as example."
John Locke (1632–1662) Philosopher and Economist
Complaints about excessive executive pay continue to feature in the media, and yet it continues to rise, above all in public corporations. This increase in executive pay is not market driven; it is the consequence of collaboration by well-organized and powerful groups employed as company stewards who behave as if they are the owners. When such managerist excesses become known they give rise to public indignation: one case in point is the severance pay secretly awarded to the honorary president of Novartis, the Swiss pharmaceutical group. Not wholly coincidentally, about that time a Swiss national referendum called the Racketeering Initiative was held and approved by a two-thirds majority (the third highest approval rating in Swiss political history). Consequently the Swiss government passed an Ordinance Against Excessive Compensation, which is legally binding for Swiss public corporations from 1 January 2015.
What's it all about?
It is about nothing less than restoring a proper link between employee pay and executive pay – closing the big gap. The argument that executive pay in Europe must match that of the USA, (but nowhere else) is now being seriously challenged. That executives of DAX 30 companies earn several hundred times more than skilled workers is unacceptable because it damages group solidarity, destroys team spirit, and will eventually undermine communities and social cohesion (as the Swiss referendum proved).
Early warnings – Peter Drucker
There was no greater analyst of executive pay than Peter Drucker, a philosopher, thinker and teacher on management. Drucker's dictum was that business enterprises, despite what their owners and executive officers may think, are only justified if they benefit society as a whole. Drucker also believed that the "community" of a business enterprise is such a valuable thing itself that executive pay should not be allowed to endanger it, through pay structures that are generally considered to be unfair. Drucker argued that executive pay should not exceed 20 to 25 times that of skilled workers. He warned early on about the dangers of self-enriching executives, and the consequences – at that time without success.
Corporate executive pay is an aspect of business management and supervision which is clouded in myths. At the largest firms in Germany there are at most 500 people affected. Decisions on executive pay are taken collaboratively by executive and supervisory boards (same people in different roles). Pay awards are signed off by compliant employee representatives and an inner circle of HR consultants. Disproportionate growth of executive pay since the 1990s is justified by theories of shareholder value and pay for performance. Both of these were later revised by their academic originators due to misuse; however, those who benefit most from them still claim they are valid.
Fundamental reform is needed
To reassert appropriate pay levels for executives calls for clear and simple rules of proportionality, which attract friendly collaboration, not friendly fire. This will safeguard the proper functioning of northern European-style social market economies. A solution must be found and implemented: if all else fails, by strict legal regulation.
A Topic Too Long Neglected
Cases of excessive pay for German CEOs are mounting. Public awareness, criticism and even moral indignation outrage are the consequences, and this despite the recent introduction of a German Corporate Governance Code as well as voluntary commitments by DAX 30 corporations, which were taken to signify the first signs of improvement.
Case studies of managerists extracting corporate wealth
Klaus Esser: briefly CEO of the former Mannesmann AG. A change of control clause in his employment contract allowed Esser to pocket €30m after he himself sold Mannesmann to Vodafone.
Jürgen Schrempp: the 'lord and master' of Daimler was, for a few years, best-paid CEO in Germany. Once celebrated as "the biggest buyer of companies", he was later labeled "the biggest wealth destroyer" in post-war Germany. After leaving Daimler he was the wealthiest ex-CEO after exercising stock options worth around €100m.
Still at Daimler: In 2012, Dieter Zetsche, the current boss was third best-paid CEO of all DAX 30 corporations and held the most pension rights worth over €40m; all of this despite Daimler shares performing below-average.
Wendelin Wiedeking, the so-called 'Porsche entrepreneur', received €77.4m in 2007/08 from a profit-sharing clause in his contract. Originally, so it was claimed, he negotiated €250m severance pay after his power-grabbing attempted takeover of VW. Eventually he agreed to a mere €50m. Shortly afterwards he used his new-found wealth to join the ranks of capital investors, consultants and supervisory directors.
Cyclical notoriety is a trademark of multiple ex-CEO and 'über-clever' Utz Claassen. Hired by power utility EnBW in 2003, the still fairly young 'pensioner' departed in 2007. He was compensated for four-years of service with an annual pension of €400,000. After a court case this was revised to a one-off payment of €2.5m. Up until then he had earned €4.17m annually (fiscal year 2004). Later, after an interlude at US equity fund Cerbus (name of Greek mythological three-headed hellhound that eats only live meat) he joined energy firm Solar Millennium, a German mittelstand enterprise. He was CEO for only 74 days but still demanded his €6m 'golden parachute' upon leaving. Claassen then took the insolvent firm to a U.S. court and claimed a further €265m.
Karl Gerhard Eick was the final CEO of retail chain Arcandor. As CEO he was successor to the infamous Thomas Middelhof. After only six-months, Eick left the bankrupted firm with €15m severance pay.
Depending on their affiliation, German media either praised or criticized Josef Ackermann, CEO of Deutsche Bank, for being top-earning executive in Germany with €10m annually.
Martin Winterkorn of Volkswagen was one of the most successful corporate heads in Germany. In his final year at VW he received €17m due to a previously 'overlooked' performance-related clause in his contract. There was widespread public concern at managers behaving this badly.
These are some notable examples of "extraordinary remuneration" highlighted by the media in Germany. Perhaps it is worth asking, since such cases still occur, how effective German law (dated Aug. 2009) on "appropriate pay for executive managers" actually is. Lawmakers claim they ended the false incentives that permit such excessive remuneration. However, perhaps it was merely another alibi law: a poor legalistic reflection of what should be common morality. Maybe the lawmakers took their lead from the management consultants who invented Corporate Governance (DCGK/German Corporate Governance Codex), which gives Supervisory Boards plenty of room for tolerance, but hardly any reason to impose penalties (1). In fact, DCGK practice of publicizing executive pay has unintentionally contributed to a general rise in executive pay levels (2).
Executive pay was recently again center stage due to a "Racketeering Initiative" (Abzocker-Initiative) referendum in Switzerland (3). On the other hand, a calming effect was achieved recently by the EU, which placed a cap on banker bonuses (4). Prior to the German national elections in autumn 2013, new statutory regulations on executive pay were discussed; these would make Supervisory Boards and shareholder meetings more responsible for executive pay. However, ever-shorter intervals between new laws and codes to regulate pay are a clear sign that existing legally permissible and social acceptable levels of executive pay are still being tested to the limit by managerist executives (5).
That executive pay has such a socio-political dimension is confirmed by the latest Forsa survey of a cross-section of the German population. Three-quarters of respondents believe that managers are primarily pursuing their own personal interests, instead of working for the benefit of shareholders, customers and employees. This majority opinion is a political fact and can no longer be ignored.
The number of people in Germany who benefit from corporate executive board pay is small: up to 50 CEOs and around 500 senior executives, mostly at DAX and MDAX corporations. The socio-political relevance is hardly ever discussed openly, but this inner circle also has wide-ranging political power over the economy and society, but without any democratic mandate.
Fair executive pay has become a topic of serious discussion: but so far mostly by those institutions which work in the interest of specific groups or society in general: trade unions, churches and academia. Is this reticence a sign of culpability, a lack of moral courage, mere indecisiveness or pure self-interest? The media occasionally take interest in the topic: mostly with an eye to their circulation figures. They publish lists of CEO earnings and highlight exceptional cases (6). However, this kind of transparency may actually strengthen the upward trend in executive earnings. But as far as the media are concerned, this was never their real concern.
The topic has become political. After Switzerland, Germany was next to consider taking action (7).
Executive Pay - an uneasy story
Executive remuneration is given varying levels of attention in different countries. In Europe it has recently been publicly discussed in both Germany and Switzerland: these countries have many multinational public corporations and managers who have become orientated toward Anglo-Saxon management world. The USA and Great Britain with an individualistic understanding of work performance, as opposed to systematic teamwork, traditionally lead on high pay for executives.
USA: the land of extremes
In the USA, many employees were recently told to 'tighten their belts': however this 'essential' cost-saving measure never applied to executive pay.
The earnings of the hundred best-paid CEOs (2011/2012) extend from $18m (PPG Industries Inc.) to $100m (Eric Schmidt of Google). It is a three-class system with the media sector at the top, where CEOs earn between two and five times as much as the next best class, in the banking sector. There is then a huge gap to the third class, the 'real' economy where CEOs of oil and gas businesses lead the field. CEO pay at high-tech/software/internet firms varies widely: major players like Amazon and Microsoft pay less, although stock options also come into play. CEOs of retail corporations like Walmart and Target earn an exorbitant 600 to 1,000 times the median earnings of their worst paid workers: that is exceptional, even for the USA. In fact, that makes the nine-times-higher salary of investor legend Warren Buffet at Berkshire Hathaway seem quite modest. Neither should we forget the "golden handshakes" these CEOs take when leaving: the ex-CEO of ExxonMobil, Lee Raymond, was handed a retirement package worth $400m.
On the whole, the more anonymous and atomised stock ownership is, and the more high-earning CEOs there are on the board, the higher does executive pay become. To a large degree, executive pay reflects the ranking and image of the business sector concerned, but it also reflects the spread of managerist attitudes toward so-called governance in the USA.
Average CEO annual compensation in the USA totals around $12.3m (of which basic pay is about 10 percent and stock options usually 35 percent). The ratio of CEO earnings to average worker pay (CEO to worker pay ratio) according to the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) was 24:1 in 1965, 42:1 in 1982, 71:1 in 1989, 201:1 in 1992, 281:1 in 2002, and 354:1 in 2012 (4). Since 1965, the gap has widened by a factor of 20, which is equivalent to around 1,000 percent.
To summarize: earnings (in real terms) of most employees have stagnated for a long time; on occasions earnings have even declined, while the pay of senior executives has risen throughout by leaps and bounds (10).
Germany AG takes its lead from USA Inc.
The adoption of US remuneration practice in Germany has a short history. It was triggered by the first spectacular German-US mergers: the Daimler-Chrysler 'merger of equals' (1988) and the takeover of Bankers Trust by Deutsche Bank (1999). From then on the new benchmark for German executives was their 'peers' across the Atlantic. (11) Another driving force was a concept peddled by US strategy consultants (Stern & Stewart, McKinsey, BCG and Bain) called shareholder value as well as the idolization by German managers of highly-paid Jack Welch, the former CEO of GE, who was portrayed as 'the modern manager' by German business media. A concurrent invasion by US management consultants gave impetus to a process or movement that gradually supplanted Rhine capitalism (the social market economy) with "Kapital Kapitalismus" (as the former President of Germany Horst Köhler called it), which is also known as finance capitalism. Eventually the exorbitant remuneration of 'value-adders', in other words, corporate executives, began to be questioned. However, a suitable justification was soon found: the 'scientific' findings were that members of executive boards (Managing Boards) in Germany should actually earn more, so a substantial pay rise was overdue.
At that time, top managers in Germany were paid a lot less than US and UK executives. The average CEO of a DAX 30 corporation earned 'only' DM 1.7m (€0.85m) in 1997. But since then, the pay levels of top executives in Anglo-Saxon firms have also become the norm in Germany; also due to more global mergers involving German businesses.(12) It is noticeable that Japanese companies and executives have proved immune to this trend.
According to DSW (German association of stockholders), the average annual salary of Managing Board executives in Germany was DM1.4m in 1991. By 2001, ten years later, it was six times higher at €3.14m (one € equals two DM). By 2011, CEOs were earning €5.1m on average: equivalent to a salary rise of 126 percent over ten years.
Siemens: A case study
Siemens is a good example of rapid hikes in executive pay. Until the start of the 1990s, Siemens practiced a moderate remuneration policy, given its size and profitability. This balanced approach was upset when the first 'outsider' was hired, Edgar Krubasik, who had been a McKinsey Director. Raising the pay of existing Managing Board members to equal Krubasik's starting salary meant that top executive pay rose by around 50 percent to DM3.5m (roughly €1.23m). This pay rise was smoothed over two to three years to avoid attracting internal and external criticism. A further quantum leap of 30 percent was planned upon the in-house appointment to CEO of Klaus Kleinfeld (now with Alcoa). However, because BenQ, which in 2005 had acquired Siemens's mobile phone business, soon after announced its insolvency (which led to protests over job losses) the planned pay rise for executives was postponed, but not canceled. The biggest hike of all, doubling top executive pay, took place when the next CEO was appointed: due to a corruption affair, Peter Löscher was the first non-Siemens man appointed CEO. He came from a top executive position in the USA. Löscher was awarded around €10m for fiscal year 2007/2008 or 144 times the average salary of Siemens's non-management regular workforce. Since then earnings of Managing Board members at Siemens have been among the highest at German companies.
To put these executive pay packets into perspective (14), the highest earning CEOs in Germany earned 20 times the salary of the German Chancellor, Angela Merkel, and recently even 30 times the German Chancellor's salary!
Remuneration systems for Managing Boards have taken off. They are socially damaging because they undermine trust in corporations and undermine the social market economy, which has been crucial for Germany's political, economic and social success.
Excuses for higher executive pay
It is said that money can destroy friendships. When a lot of money is at stake, selfishness easily becomes the prevailing attitude, whether of individuals or groups. It all depends upon the moral code people live by. Whoever occupies a position of power is tempted to abuse that power. Business executives, particularly of public corporations, are aware of the liberties they can take, facilitated by atomised shareholdings and powerless shareholders; although public corporations are supposed to be democratically controlled by their owners. As described above, this managerial liberty is often misused for selfish reasons or group interests (not least of all, self-enrichment).
Failed attempts to limit abuse of power
In the USA in the 1980s, several attempts were made to limit executive pay: a penal tax was introduced on severance payments of more than three-times the basic salary; restrictions were placed on company tax allowances for salaries that exceeded $1m. However, executives found ways around these rules. In fact, the new maximum pay limits soon became the norm for employment contracts of senior executives. The creative minds of so-called Executive Service Consultants (15) and tax specialists were hired by executives to find ways of facilitating large annual payments for executives: for example entrybonuses, stock packages and complex stock option schemes (in particular unvested stock options), pension pots, other bonuses and privileges. The risk of being made accountable is avoided via Directors and Officers Liability Insurance. This is a comprehensive liability insurance for managers paid by their employer. The most creative solutions for employment contracts soon became public knowledge (transparent) and were adopted by other managers as standard. After that no more attempts were made to put a ceiling on top executive pay (except for executives of companies bailed-out by the government).
A further German-US example is Klaus Kleinfeld, ex-CEO of Siemens and current CEO of Alcoa, the US aluminum conglomerate. As a German top executive who moved to the USA he is an exception. The move was facilitated by Kleinfeld's former function as head of the Siemens holding company in the USA; he represented Siemens on the board of Alcoa, headquartered in Manhattan. Upon leaving Siemens he pocketed €5.75m under a non-compete clause. Alcoa then awarded him a "golden hello" of $7.7m, including starting bonus, removal compensation and stock options. Apparently Kleinfeld was also compensated for legal and consultant costs. If he leaves Alcoa due to change of ownership before his contract expires, he is guaranteed his present annual salary for a further two years. This Kleinfeld remuneration package could even affect the European CEO market if he returns to Germany, as predicted by the German business press.
Another case is the remuneration of Martin Blessing of Commerzbank. The Supervisory Board approved his salary of €1.3m (plus €1.75m bonus if moderate targets were reached, although they were missed). Since his appointment as CEO at Commerzbank, which was bailed out with €18bn tax money and is now part government-owned, the bank has lost over 80 percent of its stock-market value and has stopped paying a dividend.
The upward spiral in executive pay is partly driven by the growth of extra-company appointments. Other drivers are 'service organizations' which specialize in executive search and compensation. They are interested in a high "turnover" and provide a stream of new studies which all 'prove' that German CEOs are relatively underpaid.
Shareholder Value and Pay for Performance – an unhealthy combination
Pay for Performance for business executives was justified by Michael Jensen in 1976 with theories derived from institutional economics. In 1986, Shareholder Value was justified by Alfred Rappaport. The combination of these two theories provided apparent justification for monetary incentives based on simple short-term formulas. From then on, interested parties such as business management schools, management consultancies and the beneficiaries themselves, CEOs and Managing Board executives, all swore by these apparently plausible justifications (17). That the originator academics later distanced themselves from the negative consequences of these theories, maximum shareholder value and short-termism, was however overlooked in a maelstrom of personal interest and privileges.
False reasoning and specious arguments
The main arguments for higher salaries are well-known, because they are used time and again. One is that high salaries are needed to attract and keep the "best of the best", who are primarily interested in money or to demonstrate convincingly that "you have the best, because you pay the best". Finally, higher pay supposedly acts as a spur to aspiring top executives and even entire organizations, who then do their best to be like the best. A career in a company is compared to a tournament where prizes are awarded to the victors. High remuneration is supposed to act like a 'collective motivator'. So what is to be made of these arguments?
In fact, these claims are contradicted by both common sense and scientific studies (18): according to the latter, share prices of corporations with the highest paid CEOs actually perform much worse than their competitors. For every additional dollar paid to a CEO the stockholders lose around 100 dollars.
A high variable element of pay is justified by a general desire for "pay for performance" compensation. If a link between pay and performance can be clearly established, goes the argument, high pay can be easily 'communicated' and will be accepted. But in many cases there is so little variation in pay of Managing Board members that we could refer to it as "executive fee" and not "executive pay". One can only assume that the performance of every Managing Board member is somehow 'exceptional'.
Another challenge is the notorious non-transparency of Managing Board salaries. An unbiased reader of the management remuneration section (up to 10 small-print pages) in annual reports of many DAX 30 corporations could easily gain the impression that the real intention of the authors is not to report but to confuse and conceal (20).
A special situation applies in Germany when it comes to remuneration of Managing Board members because of the German co-determination system of industrial democracy (elected employee representatives hold positions on Supervisory Boards). There are also employee representatives on the Personnel Committee, which prior to the Vorst AG law of 2009 (Act on the Appropriateness of Managing Board Compensation) approved executive compensation. After the Vorst AG law came into effect in August 2009, shareholders were 'empowered' to take an advisory vote on executive pay. The employee 'side' on Supervisory Boards, mostly high-ranking trade union officials, generally approved excessive executive compensation deals: it appears that informal collusion agreements were common. It was rumored that deals were struck to approve higher executive pay in exchange for safeguarding employee workplaces; a mutual benefit alliance to the disadvantage of shareholders.
Myths and Reality
There are a number of commonly held myths on executive pay, which do not stand up to examination. The five most common are listed:
There is a functioning, international, global market for executive managers.
At least one fact appears to contradict this: the very small number of CEOs employed outside their home country (21). Also, comparing the leadership qualities of CEOs is difficult. There is no guarantee that a highly paid CEO successful in one country and culture will be successful elsewhere: there are too many variables.
High hurdles stand in the way of bonuses and targets cannot be manipulated.
In many cases, this is not true. Balance sheets can be "doctered" so that bonuses are paid out. This was the case especially before the Sarbanes-Oxley Act was passed. A general assumption of innocence means taking blind trust one step too far.
Climbing a corporate hierarchy brings a higher risk of dismissal in the event of unsatisfactory performance; this risk has to be compensated by higher remuneration. That point of view was put by IBM in the 1970s and was generally accepted. But is the risk of CEO short-term contracts being canceled much higher today: are today's huge bonuses really justified? As a rule, if networking does not do the trick, many CEOs ('leaving by mutual consent to pursue other interests') use Executive Search firms to find positions in other corporations, related business ventures or private equity firms After all, they know how to remix corporate portfolios (sell underperformers, buy outperformers) and restructure large conglomerates (manage organization charts). However, due to short-term contracts, the job of CEO has less risk of a sharp fall in earnings than do jobs of their subordinates. If CEOs truly believe they are 'employed entrepreneurs', as we are told, why do they adopt private risk-minimization strategies? It is noticeable that employment contracts for Managing Board members are more about unemployment (severance conditions) than employment, which is a clear sign of risk aversion; not a characteristic expected of self-proclaimed business entrepreneurs.
CEOs drive the company.
In the past few decades, corporations have become personified with their CEOs. There are several reasons for this: CEO egoism and narcissism, a tendency by media to personalize business news (22), equity fund managers who insist on talking to the 'boss', and business schools which teach that individual managers make the difference and CEOs matter most: storylines which appeal to paying pupils. This false image needs to be corrected: in reality recent studies show CEOs influence on total short-term financial performance is at best 15 percent: a lot less than often claimed.
Investigations by Lucian Bebchuk of Harvard University show a correlation between, on the one hand, a growing gap between CEO and other executives' earnings, and on the other hand, lower profits and weaker market ratings. Therefore the 100 percent earnings gap between CEOs and other Managing Board executives, which is quite common, has no justification in reality.
The independence and composition of a Supervisory Board guarantees that remuneration of Managing Board members is reasonable and limited.
However, Supervisory Board members are not truly independent. This is partly due to the non-transparency of both German corporations and the co-determination system of industrial democracy. Until 20 years ago, ownership relationships in German conglomerates were fairly transparent; but these major corporations have been broken up, and so contact between corporations has been replaced by personal networks at Supervisory Board level. Consider the number of executive managers on multiple Supervisory Boards (Cromme, Lehner (23), Schneider (24) and Wenning; and mutual appointments to Managing Boards and Supervisory Boards of DAX corporations like Allianz, Bayer, Deutsche Bank, Thyssen-Krupp, EON and RWE. None of these managers on multiple Supervisory Boards have acted conservatively on pay rises for Managing Boards or Supervisory Boards; instead they have repeatedly approved huge wage hikes for executives and appear indifferent to the interests of shareholders.
The formulation of compensation rules for a Managing Board is restricted to an inner circle of people on the Personnel Committee or Remuneration Committee. If you track the development of DAX 30 corporations over time and note the personnel and corporate nexus, the driver of upward harmonization of pay becomes clear. Informal mutual interests go hand-in-hand with mutual generosity.
Supervisory Boards in Germany comprise elected representatives of both shareholders and employees (the latter are representatives of management and non-management staff and representatives from the lead trade union at that corporation). The employees side, headed by the union representatives) are usually mostly interested in higher wages for employees and workplace guarantees, especially for trade union members. Of course, those decisions are taken by executive managers. So there is understandable reluctance by them to criticize pay awards for executive managers. This "mutual interest society" explains why excessive pay awards for executives are approved by employee representatives.
Executive pay is a mystery that must be exposed to the light of day. Only then can the upward trend be reversed. A sure sign of a business hijacked by managerists is secrecy about executive pay.
Peter Drucker warned early about overpaid managers
Peter Drucker (1909-2005), the greatest management thinker of the past century, was always interested in what makes institutions or organizations effective and what stops them serving the common good. This led him to consider the remuneration gap between managers and employees, again and again.
Early sobering observations
In Practice of Management (1954) his core message was that the risk of dismissal for poor performance must be balanced by rewards for especially good performance. In Management: Tasks, Responsibilities, Practices (1973), in the section Executive Compensation and Economic Inequality, he quoted studies showing that the proper gap between the pay of a CEO and employees would be between 12 and 10:1 (after tax).
According to Drucker, compensation of both managers and employees has become solely monetary and ignores other commercial and economic aspects. Trade unions who represent workers have adopted the simple formula "just more money", without taking into account the overall position of the business, its sector or the national economy. Managers have become relentless in their pursuit of ever higher remuneration. This materialist attitude became widespread in the U.S.A. after the mid-1960s. Drucker believed it was the duty of managers to cap financial incentives, not promote or exploit them. Prudence was a virtue he held in high regard. He believed it was inseparably linked to the long-term prosperity of a business, the economy and society.
In Frontiers of Management (1986) he openly criticized the "greed effect" in top management. This was a reaction to the behavior of Chrysler CEO, Lee Iacocca, who awarded himself a huge bonus, while demanding wage cuts from workers owing to the ' competitive situation' Chrysler was facing.
Critical role of executive pay
Dissatisfaction is the greatest potential "demotivator"; unjustifiable remuneration gaps are the cause of much dissent. As a general rule, a balance should be found between individuals and groups across a business. Drucker's concept for ensuring a "well-functioning society" is the absence of reasonable grounds for social jealousy.
According to Drucker, compensation is the most underrated factor affecting the legitimacy of management. He concluded that excessive pay of US managers was an intentional violation of the Hippocratic oath Primum non nocere (duty to avoid intentionally causing damage to society). He pointed out several times that this was due to a very small group. He estimated that in the USA between 500 and 1,000 CEOs/Board Members were involved, but they have enormous influence, also on the overall socio-economic structure, due to the signals they send to society. Drucker warned about such thoughtless behavior and its long-term effects.
For Peter Drucker, an imbalanced remuneration system is also a cause of misdirected management: it strongly influences strategic decisions, breeds inappropriate behavior, leads to poor results, and widens the gap between managers and society. Two impressive historical figures quoted by Drucker are J.P. Morgan Jr., the most influential banker of the nineteenth century, and George Siemens, co-founder of Deutsche Bank. Both separately concluded that a balanced remuneration system is a key criterion for judging the creditworthiness of a business. A wide gap between top managers and the rest is a sure sign of disregard for loyalty and solidarity, and clear evidence of a self-serving attitude across management, which increases the credit risk.
Drucker's solution: moderate proportionality of pay
He often said there is no single fair and just system for fixing executive pay. There is no certain alternative method for judging management performance. However, experience and knowledge is available, at least since his studies of General Electric in the 1950s, which show the benefits of proportionality within, and outside, commercial corporations.
What counts for Peter Drucker is the moderate proportionality of net income. He placed the reference marks at 20:1 for 1977 and 25:1 (after-tax) for 1984. However, he believed that exceptions were acceptable for "star managers". He supported performance-related pay on the whole, but not individualistic and widely differentiated pay systems. Nevertheless he clearly rejected leveling. He also appreciated that outstanding contributions such as inventions or innovations deserve special reward.
Whenever the status aspect of money ("make believe money") drives remuneration to unprecedented heights, Drucker suggested such "excess pay" be donated to charitable causes (25) or even better, refused. Perks like private business jets and country club memberships are inappropriate. Top managers themselves should decide what extras they want and pay themselves. What he called "golden fetters" (today's golden handcuffs), excessive pension rights and stock options should be withdrawn, because they are an inappropriate way of obtaining loyalty, and only benefit a privileged few.
From a modern perspective, Peter Drucker adopted a "radical" position on executive pay. Back in 1984, he strongly criticized the pay of executive managers ("overpaid directors: greed and its consequences") and also argued for a more equitable society. If imbalances become too large they seriously disturb the proper functioning of society. A social backlash against unjustifiable executive remuneration can then be expected. His judgment on the behavior of managers awarding themselves pay rises while cutting the workforce is clear: it is "morally unforgivable".
Peter Drucker predicted the undesirable developments we are now experiencing; he believed that moderate differences in pay were in everyone's best interest. Today we are farther away from that than ever.
Time for fundamental reform
The degree to which CEO/executive manager pay can affect a workforce and business is often underestimated by business leaders. If basic demands for fairer pay are not taken into account by the head of a business, it can have far reaching consequences.
Good bye to managerism
CEOs and executives who are manageristic and regard companies simply as cash generators and set a target of constantly rising market capitalization (rising share price) see business leadership in simple terms: they use as few resources as possible, as few cheap employees as possible, use light capital assets and wherever possible outsource production, and hire external consultants to prepare decision-making, as and when required. They attach key importance to spending on marketing and PR to maximize brand value. The orchestration of global value-added chains, margin management and professional presentation of the business to capital markets (equity fund managers) serve to justify short-term "value added bonuses" without limits, and also without penalties for negative outcomes. CEOs characteristically overestimate their own importance and long-term "impact"(26). This illusion is matched by stockholders and Supervisory Boards who believe that they themselves are the "supervisors" and "masters" of their business. According to the economist Kenneth Galbraith and others, in truth Managing Boards and CEOs are the true "masters". This caricature of responsible business leadership is the real reason for ever higher executive pay.
Other ethical standards – other role models
Once a high level of earnings is reached, the real value of additional pay will decline. This is shown by numerous studies into well-being and happiness. Moreover, reducing inequality is an effective means of raising the quality of life for everyone. Scandinavian countries with a more equal distribution of wealth (the lowest Gini coefficient) exemplify the advantages of equitable societies: harmonious social relations, a high quality of life and a pleasant environment. Earnings of managers are subject to traditional social rules according to which a moderate gap to earnings of other members of society is the expected norm. The level of CEO and executive pay in the Nordics is well below that of other European countries: in Denmark and Sweden it is 25 percent less, and in Norway and Finland lower still – despite generally higher levels of both taxation and cost of living, and many multinational businesses. CEO pay is generally below €1m. In Sweden, the Nordic country with the widest pay gap, the spread between top and bottom salaries is 1:50 (in 1990 it was 1:9) (27).
Respect for generally valid principles
Corporate executive managers should commit to generally valid principles of business leadership. The first principle: cause no damage to valid interests of business stakeholders. This requires a corresponding understanding by CEOs and executive managers of themselves as stewards/trustees (acting as "servant leaders") on behalf of stakeholders with constant reference to the principles of cooperation and community.
Finally, today's emphasis on remuneration also demands those responsible to be careful and circumspect when evaluating the true contribution of individual executives. Executives who aim to circumvent such evaluations by deploying so-called incentive systems with complicated formulas, purposely developed by bought-in consultants, are unprofessional, to say the least. Neither are such pay levels reliable indicators of market forces. Potential earnings of Managing Board executives have risen by at least one-third, not in line with market forces, but in line with the law of communicating vessels.
Reasonable, understandable rules for executive pay
A well functioning economy requires those in positions of responsibility to accept the need to engage both workforce and individuals in a common purpose, to take this seriously, and prove it by themselves agreeing to follow the rules.
Below are eight rules for executive manager pay that could find broad acceptance across society:
- Clear relationships (Drucker Principle) between net earnings of business leaders and average workforce wage.
- Proportionality within the Managing Board and to next lower levels with a maximum gap of 30 to 40 percent.
- Take full account of social context and orient toward equitable societies of Scandinavia (28) or even Japan or China. Disconnect Europe from the 'compensation' practices of the USA.
- Annual review of decisions on pay (take account of employee satisfaction surveys) by owners (not by Supervisory Board or Compensation Committee) (30)
- Simplicity and transparency of solutions covering total cost of Managing Boards (Total Cost of Management including cost of consulting, opinions/certifications and lobbying) A clear presentation of the cash value of pension accruals and severance packages.
- Ensure long-term sustainability
Stock purchases to be held for a minimum term of five years. Stocks as a central and proportionate element in remuneration packages are acceptable if subject to rules on long-term retention and accounted as expenses.
- Include risk and personal liability(31)
Exclude comprehensive D&O (non-insurable personal component if more than one-and-a-half times higher than basic annual salary).
- Exclude perks (private use of corporate aircraft, country club membership and so on). Limit company pensions to a maximum of five years of salary. No signing-on bonuses).
A further proposal puts this into perspective: take account of social acceptance and sustainability. A maximum range of 50:1 between business leaders and skilled workers is acceptable. This is consistent with top wage levels in Scandinavia. In large family/trustee businesses – apart from exceptions like the media sector – the pay of top executives is 10 to 12 times that of skilled workers.
In German politics and business the consensus among employers (executives) and employees (trade unions) is that employee pay should somehow be regulated (including executive managers). Well-managed medium-sized enterprises could be used as the benchmark.
Executive pay: a test of good governance
Executive pay is a good indicator of the quality of corporate governance and sensibility for social themes. The recent level of corruption and greed was inconceivable in the past. Legislation on executive pay is nothing more than a political reflex and loose regulation. The whole approach has a patchwork nature.
One thing becomes clear: what matters most is not detailed change of specific regulations, but a completely new orientation. Looking to the future, it must be understood that businesses need to have a consistent pay structure across the whole workforce
It is unacceptable that top executives point to the "east" (Eastern Europe, China) on non-executive worker pay, but on their executive pay they point to the "west" (the USA). (32).
Contradictions must be resolved because the "top executive cost" of Managing Boards is rising disproportionately, as if somehow the regular activities of CEOs deserve extra-special rewards (33). Cost savings which affect workforces, but exclude the Managing Board should not even be considered. A practical response to such abuse of power would be to exclude executives of these Managing and Supervisory Boards from peer group organizations.
We need to significantly enhance the social reputation of company heads and business executives: their standing must be raised to levels found in Nordic countries. This will benefit social cohesion and collaboration and also strengthen the general economy.
It is indispensible that CEOs and members of Managing Boards act as role models. Credibility and trust have to be earned, they are not freely dispensed. This means that those with responsibility must state their view on their own pay (34), ensure transparency and behave prudently. If CEOs fail to do so, the only viable alternative is strict statutory regulation.
- Drucker Peter F. Overpaid Executives in: The Frontiers of Management, Where Tomorrow's Decisions are Being Shaped Today Truman-tally Books, New York, 1986.
- Drucker Peter F.: Management: Tasks, Responsibilities, Practices Harpers & Row, New York, 1973.
- Frey Bruno & Osterloh Margit: Yes, Managers Should be Paid Like Bureaucrats Journal of Management Inquiry, March 2005
- Galbraith John K. The Economics of Innocent Fraud: Truth for our Time Houghton Mifflin Harcourt, Boston, 2004.
- Hoefle Manfred Managerismus Unternehmensführung in Not Weinheim, 2010.
- Jensen Michael C. & Meckling Williem H. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure Journal of Financial Economics, 3/1976.
- Lafley Alan, G. Executive Pay: Time for CEOs to Take a Stand Harvard Business Review, May 2010.
- Ulrich Jürgens & Joachim Rupp & Katrin Vitols Shareholder Value in Deutschland – Nach dem Fall von Mannesmann, Wissenschaftszentrum Berlin, Berlin, 2000.
- Wilkenson Richard & Picket Kate The Spirit Level – Why More Equal Societies Almost Always Do Better, Allan Lane/Penguin Books, London, 2009.
The Economist Why the world should look at Nordic countries 2 Feb 2013.
Frankfurter Allgemeine Zeitung, Focus, Wirtschaftswoche, Fortune, Wall Street Journal.
(1) Apart from political appeasement the value of such a law is questionable because the criterion of proportionality is already covered by article 87 AktG, but to no effect.
(2) A clear example of the consequences of publication is provided Siemens.
(3) A vote was held on 3 March 2013 and approved by 67.9 percent; the third highest "Yes" vote of any Swiss referendum.
(4) "For the first time in the history of EU finance market regulation, bonuses for bankers were capped," said the parliament's head of negotiations, the Austrian member of parliament Othmar Karas. "On principle in future banker bonuses must not exceed that banker's basic salary."
(5) The European Commission planned a comprehensive package of measures to limit executive pay in all sectors by year-end 2013 to include severance payments, new transparency rules as well as salaries. "The shareholders of all public corporations in the European Union should decide the size of executive salaries including 'golden handshakes' said EU Commissioner for Internal Market and Services, Michel Barnier.
(6) German media regularly criticize the gap between German and US executives. A Focus magazine headline was, "US CEOs earn a lot more. Despite their apparently high pay, German corporate executives can only dream of the salaries their colleagues earn in the USA." At the same time the German media condemn "excessive" manager salaries. A leading publisher of pay ranking lists is Manager Magazin.
(7) It is remarkable that not one of twenty professorships for business ethics in German-speaking Central Europe has commented on executive pay. The fundamental analyses of Bruno Frey and Margit Osterloh, University of Zurich, have received little attention.
(8) In the case of ExxonMobil, the four largest 'shareholders' are mega funds with a combined holding of only four percent. ExxonMobil has a typical atomized shareholder structure: it belongs to "everybody and nobody".
(9) The widest gap was 525 in the year 2000.
(10) The dimension is clear when hedge fund managers are included: total earnings of the twenty-five top-earning hedge fund managers exceed the total earnings of the 500 CEOs on Standard & Poors Index; these are the "kings of confidence tricksters". Heads of business strategy consultants and of law firms earn about the same as CEOs.
(11) Robert J. Eaton the CEO of Chrysler pocketed seven-times more than Schrempp.
(12) Ulrich Hartmann, former CEO of Veba and member of multiple Supervisory Boards, predicted at the end of the 1990s that German companies would copy the US executive compensation system; this was a self-fulfilling prophesy because he himself 'co-piloted' the shareholder value concept in Germany.
(13) This leads us to the earnings of a McKinsey director, who earned considerably more as Key Account Manager for Siemens than the Siemens Managing Board executives themselves.
(14) See Günter Ogger Ackermann, Winterkorn und der Neidfaktor, www.managerismus.com
(15) Most prominent are Tower Watson (14,000 employees), Hay, Kienbaum and Egon Zehnder.
(16) A "co-determination" say-on-pay regulation for shareholders proposed in the U.S.A. in 2007 failed to pass the Senate. Yet bail-out businesses and banks are rescued by government.
(17) See Creating Shareholder Value a seminal book by Alfred Rappaport; and a path finding article Theory of the Firm, Managerial Behavior, Agency Costs and Ownership Structure by Michael Jensen & William Meckel, Journal of Financial Economics Vol. 3(4) 1976 p. 305-360; and It's not how much you pay, but how Jensen M.C. & Murphy K.J., Harvard Business Review 68(3), May-June 1990 p. 138-153; and Just Say No to Wall Street: Putting a Stop to the Earnings Game by Fuller J. & Jensen M., Journal of Applied Corporate Finance, Winter 2002 p. 41-46.
(18) Study headed by Raghavendra Rau of Purdue University.
(19) For many years the spread of total earnings of Managing Board members at Siemens was around 2-3 percent; this with a supposedly significant personal performance element, despite widely varying management performance clearly apparent to the workforce.
(20) A non-competition clause worth €58 million for the Honorary President of Novartis, Daniel Vasella, at first 'unnoticed' by the Supervisory President, Lehner, caused outrage; Vasella then left Switzerland for the U.S.A.
(21) A recent study on Global CEO Appointments by the High Pay Centre, an independent U.K. think-tank, found that in fact only 0.8 percent of CEOs of Fortune 500 businesses were cross-border appointees.
(22) So-called 'writing up' and 'writing down' by the media has consequences.
(23) Ulrich Lehner, as well as a board member on trusts, committees and associations, Chairman Supervisory Board of Deutsche Telekom, Thyssen-Krupp, E.ON, Porsche and President IHK (Chamber of Commerce) Düsseldorf, he was also Vice Chairman Board of Directors at Novartis when Daniel Vasella was granted his 'separation allowance'.
(24) Martin Schneider was Chairman Supervisory Board of Bayer, Linde and RWE as well as a Supervisory Board member of Daimler, TUI, Metro and trustee of the Thyssen-Stiftung (Thyssen trust).
(25) It is a common attitude of board members in Germany. In response to criticism of his pay, J. Ackerman, Deutsche Bank, said his pay level was hard to communicate, but his international role and a peer comparison (with Wall Street and City of London) was explanation enough; also there were numerous Deutsche Bank employees, above all traders, who earned many times more than he did.
(26) Referred to in the U.S.A. as the "Lake Wobegon Effect".
(27) Two comparisons: The CEO of Sandvik ?(Sweden), a leading industrial business, received about 27 times less (including stocks) than a U.S. peer CEO. The head of Swedbank, one of the biggest banks in Sweden, received one-twenty third the pay of the ex-head of Barclays bank (U.K.). A historical comparison; in 1999, the hype year for telecommunications, the CEO of Motorola (U.S.A.) received 58 times more than the CEO of Ericsson (Sweden).
(28) Public trust in corporate governance is twice as high there than the EU average.
(29) Twenty times higher is recommended by trade unions at WEF for the G-20 Agenda. In Japan the difference is eight to ten times.
(30) Even this solution is questionable due to many short-term incentives to boost share prices.
(31) It is remarkable how even 'corporate disasters' never trigger a repayment of bonuses and bonuses are never withheld pending future outturns (e.g. Arcandor and Porsche). Liability under the Business Judgement Rule is very loosely defined: "... business decisions reasonably assumed to be in the best interest of the business based upon a proportionate amount of information available". Liability law suits are mostly only triggered by formal errors in publications (e.g. financial reports); these are covered by D&O insurance.
(32) CEO remuneration at leading, globally active Chinese businesses such as Huawei (telecomms and Haier (household appliances) are one-tenth less than CEO salaries of German and U.S. companies. It would be interesting to compare them with world-class South Korean firms like Samsung and Kia.
(33) Other examples are huge transaction bonuses given to CEOs and CFOs of IPO firms: placing businesses on the stock-exchange, anyway and anyhow, is rewarded much better than forward-looking innovation.
(34) Alan G. Lafley (former and reappointed CEO of Proctor & Gamble) and admirer of Peter Drucker), "It's time for CEOs to take a stand. In fact, I had no employment contract, no severance, no change-in-control payments, no gross ups, no pension (beyond stock from a modest profit-sharing trust that all P&G employees participate in) and no supplemental retirement plan, and 90% of my pay was at risk in the form of restricted stock and stock options."