Internal Pay Equity

by Frederic W. Cook, Chair, Frederic W. Cook & Co.

During the last 30 years, compensation administration has moved from a balanced approach considering both internal equity, based on job evaluation, and external competitiveness, based on surveys, to an approach that relies almost exclusively on surveys.  Being competitive has replaced being fair and equitable. This, among other factors, has caused CEO pay to rise faster than the pay of other executives and employees, resulting in the widening CEO pay gap.

When all positions are matched to the market, any proper internal relationship between positions gets lost.  This is especially true with CEOs whose pay has increased at a faster rate than other executives' pay.

Surveys now tell us that CEOs in large companies are paid 5-7.5 times in total compensation the pay of the heads of their direct reports who run major divisions.  Is this pay gap reasonable?  I have not heard of it existing at any other reporting levels in a large public corporation.

Such a stalwart of American capitalism as J.P. Morgan is reputed to have had a rule that he would not invest in a company whose CEO was paid more than 50% above the executives at the next level.  He reasoned that, if the CEO was paid more, he wouldn't have a team but only courtiers.

I had the privilege, several years ago, of working with the CEO of a very large company shortly after he took office.  He realized that CEO pay was rapidly out-pacing not only the pay of the average worker but also that of his direct reports.  He also realized that global competition and the drive to reduce costs would mean that his regular, mostly non-union people would not be receiving much in the way of pay increases, and even would be experiencing benefit cutbacks and takeaways.  If his company was successful, he and his executives would benefit the most because their pay was driven by performance and options.  He worried that the other employees would realize they were not benefiting from their productivity improvements and sacrifices, which helped create that performance, and that they might withdraw their support.  He went to his compensation committee with two proposals.  First, that his own cash compensation be capped at 150% of the average cash compensation of his major division heads.  Second, he proposed a one-time, all-employee option grant of 100 shares.

Unfortunately, very few large companies have followed this leadership example.  I would encourage those of you who are drawn to the idea of internal pay equity to ask your HR heads or consultants to look at the CEO pay ratios that existed in surveys five, ten or more years back, and then ask yourself whether the current ratios are justifiable and sustainable, or whether some other approach to setting CEO pay might be more reasonable.