The Advisors' Blog

– Broc Romanek

Here’s an excerpt from this article by Alex Edmans:

I strongly believe that executive pay should be reformed. My own research demonstrates the substantial benefits to firms of treating their workers fairly. However, disclosure of pay ratios may have unintended consequences that actually end up hurting workers. A CEO wishing to improve the ratio may outsource low-paid jobs, hire more part-time than full-time workers, or invest in automation rather than labor. She may also raise workers’ salaries but slash other benefits; importantly, pay is only one dimension of what a firm provides. Research shows that, after salary reaches a (relatively low) level, workers value nonpecuniary factors more highly, such as on-the-job training, flexible working conditions, and opportunities for advancement. Indeed, a high pay ratio can indicate promotion opportunities, which motivates rather than demotivates workers. A snapshot measure of a worker’s current pay is a poor substitute for their career pay within the firm.

The pay ratio is also a misleading statistic because CEOs and workers operate in very different markets, so there is no reason for their pay to be linked — just as a solo singer’s pay bears no relation to a bassist’s pay. This consideration explains why CEO pay has risen much more than worker pay. As an analogy, baseball player Alex Rodriguez was not clearly more talented than Babe Ruth, but he was paid far more because baseball had become a much bigger, more global industry by the time he was playing. Even if the best player is only slightly better than the next-best player at that position, the slight difference can have a huge effect on the team’s fortunes and revenues.

I agree with some of what Alex says – but he also doesn’t understand that boards can take internal pay into consideration as just one factor in their decisionmaking. And instead of comparing pay ratios of different companies – a company should just be looking at its own pay ratio over an extended period (ie. decades).

In fact, one of the main reasons why a company should be doing this internal look is that comparing a CEO’s pay package to peers is one of the primary reasons how we got into this mess – peer group benchmarking where everyone got paid in the top quartile for years & years…