Investors who want to do good while still doing well shouldn’t worry too much about high levels of corporate profit. They should worry about exorbitant executive pay.
Income inequality remains the elephant in the room for asset managers who factor environmental, social and governance criteria into their investment decisions. It is an important one, though. Principles for Responsible Investment, a United Nations-supported network of investors, warns that it can fuel political unrest as well as debt-driven financial instability.
There has been a lot of attention paid to how much of national income goes to profits instead of workers’ pay. Labor’s share of gross domestic product remained close to a postcrisis low in 2019 amid record corporate earnings, according to the latest U.S. data.
But ESG investors are, after all, still investors. Even they would have a hard time foregoing profits to raise workers’ salaries and tackle long-term issues of income inequality. The good news is they may not need to.
For much of the 20th century, the split between pay and profits remained stable, which many economists saw as proof that market economies gave everyone just deserts. Since the 1980s, though, the balance has appeared to tilt toward the latter. Because corporations are becoming larger and industries more concentrated, many point to inequality as the explanation for their accumulating excess profits. Companies, they reason, are either ripping off customers, funneling money from workers to buybacks and dividends, or both.
But there wages and earnings may not be a zero-sum game: History shows that both can move in lockstep because raising pay increases not just firms’ costs, but also their revenues. Henry Ford famously paid his workers a then-generous sum of $5 so they could afford to buy his cars.
There is also scant evidence of earnings being higher because oligopolies hurt customers. Research finds no clear relationship between firms’ market share and profit margins.
Companies’ slice of the pie hasn’t even grown that much. At its highest in 1970, labor income in the U.S. was 65% of GDP. At its lowest in 2010, it was 59%—a small change. The shifts seem to be explained by property-rent increases, the cost of replacing aging machines and the shift toward self-employment. None of these are the “profits” equity investors care about.
Of course that doesn’t mean market economies ensure fairness. Increasing inequality is well documented and ESG investors can’t disregard it.
One alleged culprit is low interest rates that have boosted asset valuations and thus wealth not counted in GDP. The effect appears small, though. A more convincing explanation is that the struggle isn’t between profits and wages but between different types of wage-earners.
Globalization has concentrated gains among fewer, larger firms: A great chunk of rising income inequality is explained by widening pay differences between companies. Breaking up the winners is a clumsy solution and fund managers wouldn’t be doing their clients any favors by clamoring for the government to do so anyway.
But there is something else they can directly influence: top-level pay. From 1978 to 2018, the inflation-adjusted compensation of American CEOs grew 1,000% and that of very high earners 339% whereas wages for the typical worker were up just 12%, according to the Economic Policy Institute. Research shows that executives, managers, supervisors and financial professionals account for 70% of the income gains of the top 0.1% between 1979 and 2005.
Inflation in CEO pay took off just as trade unions weakened, suggesting a link. The trend seems to have softened in recent years, but the gap remains huge. And, unlike pay raises for factory workers, giving rich people checks doesn’t raise consumption much.
This problem is the culmination of what business historian Alfred Chandler dubbed the “managerial revolution.” By the 1920s, professional managers had taken control of corporations as stock markets dispersed their ownership—a necessary step to avoid the grandchildren of founders running businesses into the ground. Today, 80% of the Russell 3000 is owned by institutional investors, including index funds.
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Boards either have little power or are made up of insiders. Last month, new Boeing CEO David Calhoun argued that having been a director since 2009 had only given him “a front-row seat” to the problems that led to the company’s 737 MAX crisis.
Figures by economist Emmanuel Saez depict the power shift from owners to managers: A century ago, the 0.1-percenters’ main source of income was capital; now it is pay and business income.
Glaring examples include toy-maker Mattel Inc.’s former CEO Margo Georgiadis, who made 5,000 times the salary of her median employee in 2017, her first year at the helm. When she left the company in 2018, its stock was down 50%. Or Discovery Inc.’s David M. Zaslav, who keeps topping rankings: In 2018, he got paid $130 million, which was 22% of the company’s net profits.
Pay has also skyrocketed at investment banks, consultancies and private-equity companies, which are, after all, outsourced managerial structures. Even founder-centric technology giants like Microsoft Corp. are transitioning toward professional management.
Shareholders shouldn’t wrest back day-to-day control—managerialism is a necessary evil. For too long, though, governance concerns have been centered on aligning manager and investor incentives through strategies like stock options. That just ended up making CEOs richer.
Investors can change this by using their stewardship to impose a fairer distribution of pay. ESG criteria may even help rehabilitate the role of trade unions in cementing longer-term corporate stability.
A little progress might make investors feel less awkward about uncorking the champagne after a bonanza earnings season.
Write to Jon Sindreu at email@example.com
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