The knock-on effects of CEO pay

Sep 29 2006 by Brian Amble Print This Article

Excessive CEO pay could be having much greater effect than previously believed, increasing employee turnover lower down the organisation and damaging returns to shareholders.

Executive compensation scholars have released new, breakthrough research analyzing perceptions of fairness in executive pay and how CEO over- or underpayment cascades down to lower organisational levels.

A new U.S. study, "Overpaid CEOs and Underpaid Managers: Fairness and Executive Compensation," looked at data from over 120 firms over a five-year period and found that CEO pay has direct consequences for compensation lower down an organisation.

This is because the effects of CEO overpayment cascade – at diminishing degrees – down to subordinates.

For example, where one CEO was overpaid by 64 per cent, individuals in the same company at Level 2 (COO, CFO, etc.) were overpaid by 26 per cent, while individuals at Level 5 (division general managers) were overpaid by 12 per cent.

The study, published in the September/October 2006 issue of Organization Science, argues that the cumulative effect of this systemic overpayment impacts overall organisational performance as well as shareholder value.

"Given the large sums paid to some senior executives, the total cost for overpayment could be a big number – and, in some cases, significantly affect shareholder returns," said Professor Charles O'Reilly of the Stanford Graduate School of Business, a co-author of the report.

What's more, CEO pay also has a big impact on employee turnover. The study found that CEOs are a beacon for employees in determining whether their own pay is fair. Simply put, if the CEO is overpaid, subordinates are more likely to leave.

The "turnover effect" becomes more pronounced the farther away you get from the CEO level. It also appears that even if an employee is overpaid relative to the market, if their CEO is overpaid by a larger percentage than they are, they will be more likely to quit.

"CEO compensation impacts employee retention more than we realized," said lead author James B. Wade at Rutgers University. "Our research found that CEO overpayment is related to turnover, which can have important long-term consequences.

"It is quite possible that those most likely to leave because of perceived unfairness are precisely those employees coming up in the organization that would eventually rise to the top management team level."

But on the flip side, underpaying a CEO also has similar effects. Low pay cascades down with multiplying effects. Yet the researchers also found that if the CEO is underpaid more than you are, you are less likely to leave, but if the CEO is underpaid less than you are, you are more likely to leave.

As Professor Wade put it, "Underpaying a CEO could reduce turnover if subordinates are underpaid less than the CEO is underpaid."

One reason for this cascade effect is that CEOs tend to be concerned with the perception of fairness. If the CEO is paid generously, he or she will typically use their influence to pay others generously as well. And, if they are seen as being underpaid, that will also have an effect.

"Our research shows evidence that CEOs are concerned with fairness, and that they are likelier to share rewards than they are to share burdens," said co-author Timothy Pollock of Penn State University.

"But this can be expensive and has the potential to hurt a firm's bench strength if the rewards aren't fully shared."

For senior executives, meanwhile, the message is to work for a powerful boss. CEOs who also serve as Chairman of the Board tend to pay their employees more, an effect that is more pronounced at higher levels, but diminishes at lowers levels.