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A proposal made by Vincent Cable at the Liberal Democratic Party conference contained a suggestion to require firms to report the ratio between CEO compensation and the compensation of the median firm employee. At first glance, this seems like a worthy idea - the gap between the compensation of CEOs and workers has grown considerably since the 1970s. However, first impressions can be deceiving, and very hard to translate into tight, reasoned arguments based on the governance objectives, even the governance objectives of Mr Cable.
The same document states that the goal of CEO compensation reform is to produce compensation which is ‘well structured, linked to the objectives of the company’. Well structured compensation aims to acquire CEO talent at minimum cost to the firm. Disclosure provisions can further this goal by helping shareholders, creditors, and potential investors assess whether CEO compensation is, in fact, well structured. How requiring firms to disclose the ratio between CEO and median worker compensation advances this objective is a bit mysterious. Presumably, the ratio would be used to assess whether CEO compensation is excessive. Such a ratio would be a meaningful measure of excessive compensation only if median worker compensation at a given firm were in some way related to that firm’s cost of acquiring CEO talent. However, I know of no evidence or support this sort of relation and cannot even think of a strong argument in its favour.
Is there any reason to believe that the cost of acquiring and retaining CEOs for a high-median-salary accounting firm is greater than cost of acquiring and retaining CEOs for a low-median-salary catering firm? What should a shareholder of such a catering firm do if she discovered that the CEO/median worker salary ratio for her firm was very high relative to other firms? Conclude that the firm’s CEO must be overpaid because plotting strategy for catering firms requires less CEO talent because median worker’s compensation is low? Would a shareholder in the accounting firm be comforted knowing that although, the firm’s CEO is highly paid, the ratio is low? I doubt either shareholder would find this ratio of any use in judging their CEO’s compensation package.
Even comparisons between firms in the same industry are dubious. Consider two firms of comparable size operating in the same industry. In one firm, both the CEO and the median worker are paid twice as much as the CEO and median worker of the other. If the higher-paid CEO defended his salary by trotting out the CEO-to-median-worker compensation ratio, would any rational investor be satisfied with this defence? Might the investor simply conclude that the same governance process that led to CEO overpayment also generated median worker overpayment? The investor might want more information to be disclosed regarding the credentials of the CEO, his/her past performance, structural differences between the two firms, etc. However, I cannot imagine how the ratio itself would provide useful information for assessing the CEO’s compensation.
It appears that the ratio really attempts not to provide a useful governance metric but rather a measure a social inequity. Even if we grant that the ratio does point to a social problem, it does not follow that the ratio is meaningful for governance - tasking CEO compensation committees with lowering overall social inequity is both ill advised and futile. CEO compensation levels account for only small fraction of income variation. However, even as a measure of inequity, the ratio seems quite flawed. Simply matching highly-paid workers with highly-paid CEOs may lower the ratio even if the average compensation differences between high-paid and low-paid workers and workers and CEOs remains constant. Consider, for example, a world consisting of 100 workers and two firms, each firm having a CEO.
Forty of the workers are high paid and earn £50,000 p.a.; sixty of the workers are low paid earning £20,000 p.a. One CEO is low paid (for a CEO), earning £1m p.a. and the other is high paid, earning £10m p.a. If each CEO manages the same mix of high and low-paid workers, the median worker compensation for both firms will be £20,000 and the ratio at the high-paid CEO’s firm and low-paid CEO’s firm will equal 500:1 and 50:1 respectively. Now suppose that all the high-paid workers migrate to the high-paid CEO’s firm and all the low-paid workers to the low-paid CEO’s firm. Now the ratios at the high and low-paid CEOs’ firms are 200:1 and 50:1 respectively. The average ratio of CEO pay to median worker pay has fallen without any change in the actual distribution of wealth. In short, even as a measure of inequality, the ratio is rather problematic. Of course, increases in income inequality, everything else being equal, will lead the ratio to rise. But the ratio per se is more of an effect of something that might deeply bother us as a society - income inequality - than itself the cause for concern. The demand for disclosure of the CEO-to-median worker compensation ratio thus seems to reflect revulsion at high levels of CEO compensation in a word of stagnant real wages rather than a reasoned attempt to provide a useful metric for evaluating CEO compensation.
See also: ‘Realistic rules of compensation – the rules of the game’.
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Comments
There is a methodology. If you believe that no worker should cost more in leadership, management and supervision than (s)he is paid to do the job - a plausible ratio - you conclude that each tier of management should cost no more than half the tier below.
So any manager taking more than half the total of his or her direct reports is out of line with this benchmark. The ratio depends on how you value leadership, management and supervision.
Market forces must not be the rationale for top salaries. High salaries do not generate talent - the same talent is there however much or little you pay. The market force fallacy simply cause a top pay bubble when, as now, there is clearly not enough real talent to go round.