Is there any real importance to the ratio of CEO to average worker pay?

Originally posted September 28, 2010.

The September 17, 2010 article in Financial Times (CEO/employee pay ratios) again addresses the nagging question of the seemingly outrageous difference between CEO pay and that of the average worker but raises the question as to whether a larger or smaller differential is “better”. The author writes: “Would you work harder if the ratio [between the CEO’s pay and yours] was higher or lower? So called ‘tournament’ theories of income differentials reckon that higher is better…[but] others say that the level of chief executive pay is obscenely high and that investors have a right to know which firms reward bosses too much relative to the peons.”

Peons? OUCH! But let’s not argue the semantics of arrogance.

Say on pay is here to stay. Companies who are outliers with relatively high executive pay will be loudly criticized. When these rules are in full effect, there will be plenty of positioning on the part of CEOs and Boards to defend their numbers and on the part of shareholder activists and shareholder advisory groups (such as RiskMetrics) to overturn them. But we predict that the powerful motivator of peer pressure and an instinctual desire to avoid bad publicity will have a hand in reining in executive pay, or at a minimum changing the pay mix.

However on the other side of the equation, the CEO may be more important to a company that even his (or her) presumed outsized pay would suggest. Look at Mark Hurd whose departure from HP caused the stock to drop about 10% (or the equivalent of $10 billion in market capitalization) and when his hiring was announced at Oracle that stock increased 5%, or about $6.8 billion. (Read more in our blog It’s Not Hurd on the Street Any Longer). Mark Hurd and other “celebrity executives” can clearly have an enormous and lasting impact on a company.

Scarcity – the theory of supply and demand – might also be an issue here. There could be many folks who would happily line up for a multimillion dollar job, but there are not that many that could pull it off successfully. If recent developments have taught as anything, it is that effective CEOs are not a dime a dozen, though newly minted college grads or even seasoned mid-level executives (i.e., the “peons”, perhaps) might be. That being said, we see all too often CEOs take credit on the “upside” for things beyond their control, and then say “it was beyond their control” as an excuse when things go downhill. The most effective CEO needs to be continually examining and updating the company’s SWOT analysis with a great focus on external conditions (the O and T in that analysis).

As Grahall’s Bill Burns says: “It’s not like rack and pinion steering where a 1/4 inch turn of the wheels translates into a 1/4 inch turn in the tires of a car.” A CEO’s job isn’t mechanical. Because of the complexity of organization and the business environment, CEOs must manage with intelligence, cleverness, responsiveness and strength.

The FT article concludes with the comment: “More information is always good… But beware of reading too much into information; there is no straight line from CEO pay to corporate performance.” Here we agree. While this number may have some utility as part of a broader picture, we’d be careful not to read too much into the ratio of CEO pay to that of the average worker, because it says very little about the company, its performance, its future or its strength. Pay for performance is a matter that has been overly simplified in the press. Every CEO pay package has the aspirational goal to pay for performance and many, in fact, deliver on this. But one thing is for sure, the ratio of CEO to average worker pay will never – in itself – reveal if the CEO is paid for performance or not. In fact, in a perfect world, the highest ratio CEOs would be the highest performers and the lowest would be out the door.

Grahall’s Michael Graham adds: “I am reminded of the story of Babe’s Ruth’s response when asked how he felt holding out for a salary higher than that of the US President Herbert Hoover. Purportedly Ruth said ‘What the hell has Hoover got to do with it? Besides, I had a better year than he did.’ In the end it’s all about performance and it should be! Reliance on ratios are for mathematicians and statisticians.”