I wanna make sure you’re ready, brother. Here it is: Show me the money. Oh-ho-ho! SHOW! ME! THE! MONEY! A-ha-ha! Jerry, doesn’t it make you feel good just to say that! Say it with me one time, Jerry. ” (Jerry Macquire, 1996)
You might be forgiven for assuming the dialogue I picked up from the movie Jerry Macquire was a conversation between a CEO candidate and the board member sounding him or her out. The increasing disparity in compensation packages commanded by CEOs to that of, the average employee has been a source of much debate and frustration.
Ben & Jerry’s Ice-Cream Company made a social pact with their employees when the company was founded. The company put a cap on the pay ratio between the top paid executive to the lowest-earning worker at 5:1. They held on to that ratio for 16 years. Then when it was time for Ben Cohen (the Ben in Ben and Jerry’s) to retire, they went hunting for a successor. They couldn’t find a single executive willing to accept the cap. The cap was raised to 7:1. Nada. The cap continued to be raised till it reached 17:1 over the next six years. Finally the company was acquired by Unilever USA in 2000 and nothing more was heard. The shroud of corporate secrecy descended on compensation details.
All that is about to change.
A few days back the Securities and Exchange Commission finally voted (with a narrow majority) to bring into effect a rule that will require companies to state their CEO pay as a ratio of the average worker’s pay. The hotly debated Dodd-Frank Wall Street Reform and Consumer Protection Act, is making a lot of senior executives very uncomfortable. Under the section, “Investor Protections and Improvements to the Regulation of Securities”, subtitle E refers to “Accountability and Executive Compensation.” The clause in question is as follows:
Shareholders must be informed of the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions as well as:
- the median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position)
- the annual total compensation of the chief executive officer, or any equivalent position
- the ratio of the amount of the median of the annual total with the total CEO compensation
India is a bit ahead on the curve on this one. Under the new Companies Act 2013, the provision which had been incorporated by SEBI, for Listed Companies already requires them to start disclosing this information. Reporting on this, BusinessLine states that “Under the Companies Act, 2013, every listed company shall disclose in the board’s report, the ratio of the remuneration of each director to the median employee’s remuneration and such other details as may be prescribed.”
So, why have governments decided to wake up and start tracking compensation paid to top executives? The financial collapse of 2008 and the subsequent fallout did seem to have a lot of influence on getting governments to finally act. The ‘Occupy Wall Street’ movement with its emphasis on the remaining ‘99%’ forced lawmakers to sit up and take notice. The increasing disparity in compensation between a select few and the vast majority seemed to be boiling over into a social flashpoint – any government’s nightmare!
So, how exactly do the numbers really stack up?
To get a sense of how good or bad the compensation ratio is currently; let us first try to understand what an ideal ratio in people’s minds is. The late Peter Drucker, believed that the ratio should be 20:1 (a downgrade from his earlier number of 25:1). During the time of the Dodd-Frank Law debate, Rick Wartzman wrote to the then SEC Chairperson Schapiro. He pointed out Peter Drucker’s opinion on the issue:
“I have often advised managers that a 20 to1 salary ratio is the limit beyond which they can not go if they don’t want resentment and falling morale to hit their companies,”
In a 2004 interview, Drucker elaborated further: “I’m not talking about the bitter feelings of the people on the plant floor… It’s the mid level management that is incredibly disillusioned” by king-size CEO compensation.
At the World Economic Forum, in 2010, UNI Global Union General Secretary Philip Jennings warned of ‘gathering storms’ if the CEO gravy trains are not derailed. He said that the bloated pay packets are a source of ‘systemic risk’ and added that he supported the ‘Drucker Principle’ of 20:1 pay ratio.
In this context, let us take a look at what reality is.
In their paper titled “How Much (More) Should CEO’s Make? A Universal Desire for More Equal Pay”, Kiatpongsan and Norton state that their references point that the ratio of CEO compensation to that of the average employee increased from 20:1 in 1965 to a whopping 354:1 in 2012! The ILO has a ‘slightly’ different number they arrived at from studying the ratio in the largest firms. They say that the ratio was 508:1. The corresponding ratios in Germany – the European business powerhouse was 190:1 and 150:1 in Hong Kong, China.
Closer home, global management consultancy, Hay Group released the ‘Top Executive Compensation Report 2013-2014,’ which analyzed 2524 jobs across 176 organizations and found that CEO’s in India earn around 78 times the salary of an entry-level professional. And as companies show an increased preference to recruit CEO’s from outside the internal senior management pool; this number seems bound to rise even further.
But if you pay peanuts you get monkeys!
But do you really?
Writing in the New Yorker, James Surowiecki states that, executive compensation rose 876% or nearly 9 times between 1978 and 2011 in the US. By extension one would assume that, it is 9 times more difficult to do business now than it was four decades ago!
Then, what could possibly explain this exorbitant rise in pay? According to Surowiecki it’s a combination of factors. The first is a shocking side-effect of increase transparency. With increased transparency required by law and amplified by the business press, boards at companies fall for ‘peer-benchmarking’ to determine executive compensation. And boards which are too ‘cozy’ with the CEOs, are reduced to being rubber stamps who approve pretty much anything the CEO tells them – including the justification for an outrageous compensation package. To make matters worse, this system gets played by the ‘leapfroggers’ – the CEO’s who are either extraordinarily brilliant or just plain lucky to earn huge salaries. These, then become the benchmark for others and the spiral just goes on growing!
Just how bad can it get? Roger Martin, former dean of University of Toronto’s Rotman School of Management, in an interview to Bloomberg said “When CEOs switched from asking the question of ‘how much is enough’ to ‘how much can I get,’ investor capital and executive talent started scrapping like hyenas for every morsel. It’s not that either hates labor, or wants to crush their lives. They just don’t care.”
Hmm..How’s that for employee engagement?
But CEO’s also increase investor wealth! Surely they deserve the cut?
If the financial collapse and the bonuses handed out to top executives in ‘too-big-to-fail’ is anything to go by, the assumption that bonuses and pay are necessarily linked to performance is not true. Studies published in the Economist and by others state that there is no clear correlation between CEO pay and company performance. Quite a few studies seem to have concluded that the correlation is in-fact negative!
A paper by Bebchuk, Cremers and Peyer, in the Journal of Financial Economics, titled ‘The CEO Pay Slice’, analysed the performance of companies, in relation to the proportion of what the CEO took, as a ratio of the total pay of the top five executives. It seems that the more the CEO took compared to the executives pay, the worse the company did!
In the report by Hay Group, they found that MD/CEO’s in India take close to 3 times the pay of those in Business Enabler Roles (HR Head, CIO, R&D Head etc) and Business Core Roles (Head – Sales & Marketing, Head – Manufacturing/Operations, BU heads etc)
Just when you think things couldn’t look worse, here is one final data point. It seems CEO pay is in fact strongly correlated with one metric – the number of people they fire!
Long Term vs Short Term!
SEBI in the discussion paper on CEO compensation had stated “… on an average, the remuneration paid to CEOs in certain Indian companies is far higher than the remuneration received by their foreign counterparts and there is no justification available to that effect,”
In addition to the quantum of payment, there has been much discussion around the way executive pay is structured. The incentive structure holds the key to actions taken by CEOs. Organizations in mature markets are increasingly moving away from basic incentives like, stock options and restricted stocks to performance-linked long term incentives like performance equity, performance-based restricted stock among others.
The Hay Group finds that, Indian companies unfortunately lag far behind their global peers in this aspect. The chart below on CEO Compensation mix points out the stark difference in the structuring of pay in India versus their peers in US or Europe. (The mix is fractionally better than, that for Asia on average)
With companies being now required by law to state compensation for top executives, and the ratio of that compensation to the average pay, the fallout on engagement levels will depend on how responsible (or otherwise) the top management is.
CEO’s who have taken over 100% pay increases in years where they have given zero or minimal pay increase to the average employee who is battling runaway inflation at home and increased pressure at work (because the company has not met its performance targets!) will find it increasingly difficult to justify their stand.
There is enough research (an visible social backlash) to clearly establish that there is widespread consensus that, the gap between the top executive pay and entry level pay in an organization has to reduce – substantially so, if the current trends are to be believed. Compensation forms an important component of the need for ‘Safety’ in Maslow’s Hierarchy of Needs but, it should not become the ultimate goal.
As Jack Ma, puts it succinctly – “We only eat three meals a day, we only sleep on one bed, how can you spend money? Where’s the opportunity?”
So if you are wondering why your team is looking despondent despite of all the effort you put into motivating them, the answer just might lie buried in your company’s annual report.
References and Acknowledgements:
Image in beginning of post courtesy of FreeDigitalPhotos.net.
Graphs data/image sourced from sources mentioned against the images.
- A Sweet Solution to the Sticky Wage Disparity Problem, Aug. 10, 2013, Mitchell Weiss, ABC News
- What Jack Ma plans to do with his Alibaba billions, Svati Kristen Narula, September 23, 2014, Quartz India
- UNI: In Davos, UNI warns of risks from Private Equity, CEO pay, 28 Jan 2010, ITUC CSI IGB
- Dodd–Frank Wall Street Reform and Consumer Protection Act, Wikipedia
- Executive Excess 2010: CEO Pay and the Great Recession, By Kevin Shih, Sam Pizzigati, Chuck Collins and Sarah Anderson, September 1, 2010, Institute for Policy Studies.
- What’s the best way to set CEO pay?, 03 June 2013, ILO
- Study: Tech CEO Pay Doesn’t Match Performance, Baseline, 17 Jul 2006
- Executive pay and performance, Feb 7th 2012, Economist
- Open Season, James Surowiecki, October 21, 2013 Issue New Yorker,
- CEO Pay 1,795-to-1 Multiple of Wages Skirts U.S. Law, By Elliot Blair Smith and Phil Kuntz, Apr 30, 2013, Bloomberg
- Why CEO Pay Will Keep Rising to Even More Insanely Unjustified Levels While Ordinary Workers Get Squeezed, October 14, 2013, Yves Smith, Naked Capitalism
- Top Executive Compensation Report 2013-2014, global management consultancy, Hay Group
- US follows India on disclosure of CEO-staff pay ratio, Sept 19, 2014, BusinessLine
- CEOs in India earn ’78 times the salary of an entry-level professional’, January 27, 2014, NDTV Profit
- What’s the right ratio for CEO-to-worker pay?, By Jena McGregor September 19, 2013, Washington Post
- The CEO pay slice, Lucian A. Bebchuk,J. Martijn Cremers, Urs C. Peyer, Journal of Financial Economics, Volume 102, Issue 1, October 2011