The absence of “appropriate” internal pay equity can create or imply multiple risks, including turnover in senior management, the absence of internally developed CEO successors, the presence of a “too powerful” CEO and even theft and fraud (see here). Credit rating agencies such as Moody’s take this into account, and pay equity can have a direct impact on a company’s cost of capital. But what is an “appropriate” level of pay equity?
The “right” level of pay equity is generally considered to comply with the “felt fair” principle. That is, the perceptions of the people most impacted. At executive levels it is the executives themselves. Many things impact this, but generally what is considered “fair” is roughly in accord with market standards.
Perceptions of equity vary across countries consistent with the local values and zeitgeist of the time. What is acceptable in Japan would not be acceptable in the US.
Guerdon Associates researched the market standards in Australia. We suggest that these may be a starting point for assessing the extent that an Australian company’s executive remuneration may have internal equity risk issues.
To examine internal pay equity, the logical step would be to look at pay distribution in the executive team among ASX 300 companies. The figure below illustrates how pay is distributed among the executive team as a percentage of the most highly paid individual in the firm – typically the managing director or CEO.
The following table presents the numbers behind the above figure:
From the above table, we can see that the typical second highest-paid executive in a company would be paid around 60% of the highest paid executive in the company, typically the CEO.
Comparing this to J.Pierpont Morgan’s reputed rule of not investing in a company whose CEO was paid more than 50% above the executives at the next level (the equivalent ratio being the second executive being paid 66% or less of the highest pay level), the famous capitalist would most likely refuse to invest in around half of the ASX 300. Similarly, Peter Drucker, the management guru, observed that one characteristic of poorly performing companies is that top executives are paid more than 130 percent of the compensation of people at the next level. On that logic, slightly less than 25% of the companies in the ASX 300 could be flagged as potential bad apples.
On the bright side, around half of ASX 300 companies won’t fail Mr. Morgan’s reputed rule, and more than three-quarters of ASX 300 companies do not have one of the characteristics of poorly performing companies identified by Mr. Drucker.
But the decades old observations of Messrs. Morgan and Drucker are not relevant to Australia today (and even less so, it seems, in their native USA). Market practice is, in our view, a reasonable guide. Board remuneration committees therefore should make sure that they receive an assessment of internal pay equity risk based on market standards, as well as their regular assessment of the CEO’s pay relative to market.© Guerdon Associates 2021 Back to all articles