The Advisors' Blog

– Mike Kesner, Deloitte Consulting

I wanted to follow-up on Broc’s recent blog that described a Washington Post article on the ratio of the top 350 CEO’s pay to the average working U.S. employee. The article makes much of the fact that the ratio of CEO compensation has been widening – but does not try to explain the reason this has been happening. Here is a chart that tracks equity gains realized to the performance of the S&P 500.

What is clear from the chart is there is a very high correlation of CEO compensation and the performance of the stock market since 1965. During periods when shareholders are making money, so are CEOs. (That may explain why over 98% of companies Say-on-Pay votes have passed with an average vote of 93% this past year.)

This is not by coincidence. Around 70% of CEO pay is tied to performance, and the majority of their incentive pay is tied to stock price performance in one way or another. The average U.S. employee has very little compensation tied to incentives and virtually none of it is tied to stock price. Thus, stock market gains and losses do not influence their pay.

So, it should not come as a surprise when the S&P 500 increases from 310 in the late 70’s to 1379 at the end of 2012, equity gains realized increased and the pay ratio widened. The pay ratio could have been maintained if the company provided the average employee with a similarly structured pay package as the CEO i.e., 70% of their pay at risk, and high exposure to the stock market.

That pay package, for someone earning base salary of $50,000 today, would look something like this:

– Base salary – $15,000
– Annual Incentive – $15,000
– Equity compensation – $20,000

I would guess very few employees would be willing to take a 70% reduction in base salary so they could preserve the current pay ratio with the CEO. Of course, the other alternative is for CEOs to earn less – but given the structure of their compensation package, that would mean shareholders would have to lose money.