Pay Imbalances Increase Company Risk

As if boards do not have enough to deal with – should they add to the list the level of pay imbalance in their companies?  Unfortunately, purely from a risk management perspective, it seems that they should.

Over 100 years ago the bankers’ banker, J. Pierpont Morgan, refused to loan money to any company where the CEO’s pay was 50% greater than the next highest in the company.  His rationale was that he did not trust any CEO who thought too highly of himself and paid himself accordingly.  Today, Moody’s company ratings now take into account the executive team’s internal equity.  Too big a gap between the top person and the next most highly paid indicates higher risk, assuming that there is no successor with the breadth of experience indicated by the pay levels to take over in the event of CEO termination.

More than five decades of research, mainly in the UK and USA, has documented the ubiquitous tendency that individuals have to make social comparisons with others and the consequences these social comparisons can have on individual perceptions and behaviour. This research has shown that social comparisons in organisations may lead to feelings of inequity which have in turn been linked to lower productivity at both the organisational and individual levels, loss of group cohesion, theft, lower quality, and increased turnover. 

In addition, more recent research has revealed relatively over-paid CEOs to also have overpaid direct reports, which feeds down to other levels, resulting in much higher wage bills than is necessary.  We suspect that this tendency may be more prevalent in relatively egalitarian “fair go” Australia than the class conscious UK and “winner takes all” US.

However, having a high paid CEO does not always result in highly paid direct reports or other staff.  Recent research by Charles O’Reilly, director of the Center for Leadership Development and Research at Stanford Graduate School of Business, plus others, provided additional evidence that an imbalance in the pay of chief executive officers triggers higher turnover among managers, as well as other consequences.

For the study, O’Reilly analysed data from 120 US large public companies over a five-year period, tracking five levels of senior managers from vice president to division general manager.

He found one example in which a firm paid the chief executive officer 50 percent more than the industry norm and paid the general managers 50 percent below the industry norm. At the company, O’Reilly found, turnover among the general managers was 18 percent higher than at firms whose chief executive officers were equitably paid.

Fortunately, Australian internal pay inequity is not as common or excessive as in the US.  The difference between highest and lowest paid in Australia is about 55 times – what it was in the US almost 30 years ago.  Now US CEO pay is approaching 400 times that of the lowest paid worker.

While the media has often trained its sights on why some CEOs get paid so much, there has been little focus in the research on the consequences of making a wrong decision–paying too much or too little. This and other studies provide evidence that there are consequences. Overpayment leads to an increased wage bill. That is money the shareholders would otherwise get. Overpayment of the CEO can also lead to higher turnover at lower levels, with an impact on productivity.  And, even with direct reports, there are enhanced probabilities of unethical behaviour that could result in considerable loss.

Guerdon Associates has undertaken some unique Australian research into pay inequity at the top levels, and the implications for board remuneration committees, employee satisfaction levels and company risk.  We will report on these in future issues.

© Guerdon Associates 2024
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