High CEO Pay Inspires Better Performance – Until It Doesn’t

Creating a larger differential between CEO pay and that of a typical worker can lead to better performance and lower company risk, according to a recent US study, but only up to a certain point.

Executive incentives work up to a point

The study aimed to provide some context for the US SEC’s proposed rule that would mandate the disclosure of the ratio between the median employee’s annual remuneration and the CEO’s total remuneration.

Although this rule is not yet in effect, the paper’s authors noted that financial organisations were required to disclose the total remuneration for the organisation. Using this data, the authors were able to calculate the average employee remuneration.

The research examines 10,581 data points over the time period from 1995 to 2012, which the authors noted is a broader sample than prior research, which generally focused on ratios for indices of larger companies such as the S&P 500.

Therefore, instead of a CEO pay to average employee ratio of 325 to 1 (as was reported for one study based on financial services organisations in the S&P 500) this research revealed an average ratio of 16.58 to one and a median ratio of 8.38 to one.

Even at the 90th percentile, the ratio only rose to 32.86 to one. However, pay ratios in the top decile ranged significantly higher, with the maximum ratio reaching 821.17 to one.

The research compared this ratio with performance year-on-year (measured using return on assets and the market adjusted buy and hold return for the organisation during the fiscal year) and risk (measured using the standard deviation of daily returns estimated over the fiscal year and a measure of the organisation’s distance from insolvency).

It also compared the ratio to the percentage of no votes against the organisation’s pay practices at its annual general meeting (say on pay). The latter was only able to be completed for 2011 to 2013, as organisations did not have to hold a vote on pay practices until 2011.

The research is controlled for a number of measures that are correlated with performance and risk and could influence the CEO to employee ratio, for example organisation size.

The research found a significant concave relation between the pay ratio and future pay performance – ie firm performance increases with pay disparity to a point, but as ratios rise above this level, performance begins to decline as the pay inequality becomes higher.

A convex relationship was discovered for firm risk. Risk decreased as the pay ratio increased, but after a certain pay ratio, risk began to increase again. The relationship between the proportion of votes against executive pay and the CEO-employee pay ratio was also convex, with the proportion of negative votes decreasing as the ratio increased until a certain ratio, when the proportion began to increase.

This result would appear to shed some light on the tension between two theories on CEO to employee pay ratios. The first, tournament theory, suggests that ever larger rewards are required to motivate employees to work hard and rise through the ranks until they have “won” by reaching the CEO role. The second, equity fairness theory, suggests that a smaller pay disparity between ranks is more efficient as it promotes employee morale, cooperation and teamwork. According to this research, both could be correct, depending on the magnitude of the ratio.

The inflection point for each of the curves (where a higher pay ratio ceased to have a positive effect) varied, however, the paper’s authors noted that it generally occurred at a pay ratio between 8 to one and 18 to 1.

Whether this particular ratio is valid and whether it has any relevance for Australian companies could be debated. However, we at Egan Associates would note that the general relationship matches our belief that setting CEO (and executive) pay appropriately considering internal relativities is important. Just as companies do not want to underpay, overpaying is not appropriate in a governance context.

For this reason, it is important that organisations are comfortable with the level at which they set their executive pay. They may at times be more comfortable after external confirmation that their remuneration is well within the sweet spot noted within the research.