Human Capital & Careers

High CEO Pay Is Bad for Investors and Companies

At its worst, high pay may incentivize wrongdoing by executives to meet performance benchmarks, the AFL-CIO contends.
Brandon ReesApril 18, 2017

In 2015, CEOs of S&P 500 companies received, on average, $12.4 million in total compensation. That was 335 times the average annual pay of production and non-supervisory workers.

Brandon Rees

Brandon Rees

In America, today’s CEO-to-worker pay ratios are far higher than historic levels. In 1980, BusinessWeek estimated that CEO pay at the largest companies averaged just 42 times that for rank and file workers.

At many companies, CEO pay levels are set based on a peer group analysis of what other chief executives are paid. Over time, this practice can lead to pay inflation. Although some companies target CEO pay at the median of their peer group, others point above the median. In addition, peer groups can be cherry-picked to include larger or more successful companies where CEO pay is higher.

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For this reason, compensation committees should not rely on peer group data as the only metric to set target pay levels. Rather, they should also consider how the CEO’s pay fits into the company’s overall employee compensation structure. High pay disparities between CEOs and other senior executives can undermine collaboration and teamwork. High CEO pay can also negatively affect the morale and productivity of employees who are not senior executives.

Economists for decades have studied the relative merits of egalitarian versus hierarchical compensation structures. For example, one economic theory (known as “tournament theory”) suggests that having a highly paid CEO might motivate other employees to work harder and rise to the top. Others, such as management guru Peter Drucker, argued that CEOs should not be paid more than a certain ratio of employee pay to maintain group cohesion and teamwork.

The ratio of CEO pay to other company employees is material information for investors, providing insight into companies’ human capital management strategies. According to an MSCI study, “Income Inequality and the Intracorporate Pay Gap,” companies with higher pay ratios had lower profitability than peers with narrower pay gaps over a five-year period between 2009 and 2014.

It’s not hard to imagine how pay ratios might impact a company’s performance and its returns for investors. A reasonable pay ratio sends a positive message to the workforce that the contributions of all employees are valued. The impacts of pay disparities are particularly strong in industries based on technology, creativity, and innovation. These sectors depend significantly on employees’ ability to collaborate, share ideas, and function effectively as teams.

For many companies, employee compensation is the single largest expense. Moreover, many companies state that “our employees are our greatest asset.” Yet few provide meaningful disclosure of how that asset is managed, including how employee compensation is allocated over the workforce. To address this shortcoming, the Securities and Exchange Commission will require companies to disclose their CEO-to-employee pay ratios starting in 2018.

Ironically, large pay packages may hurt companies’ ability to retain their own executives. Having achieved their lifetime compensation goals, highly paid executives may retire early or pursue alternative careers. Economists call this the “backward bending labor supply curve” — the more you pay people, the less time they prefer to work. Is it any wonder that the median tenure of U.S. CEOs has fallen in recent decades?

Of greater concern is the risk that high executive pay may incentivize corporate malfeasance. Today’s executive pay packages represent a life-changing amount of income and wealth. The siren song of a large pay package may tempt executives to make excessively risky business decisions.

At its worst, high pay may incentivize wrongdoing by executives to meet performance benchmarks. That is the lesson of the Enron-era corporate accounting scandals and the Wall Street financial crisis.

Brandon Rees is deputy director, Office of Investment, for the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO).