University of Houston
Rice University – Jones Graduate School of Business
Rice University – Jesse H. Jones Graduate School of Business
We examine the ratio of CEO to employee pay (the pay ratio) for a broad panel of U.S. commercial banks. For the vast majority of the sample, pay ratios are substantially lower than the levels popularized in the financial press. Firms with extreme high pay ratios are riskier, perform worse, and experience greater dissent on shareholder “say on pay” (SOP) proposals. However, there is an overall concave (convex) relation between the pay ratio and future operating performance (risk and SOP voting dissent). Our results are robust to controlling for the endogenous nature of pay ratios and a variety of other sensitivity tests. We also decompose the pay ratio into two components: (i) CEO to executive team pay and (ii) executive team to average employee pay. In all tests, the effects of pay disparity between the executive suite and the average employee are incremental to the effects of pay disparity within the executive suite.
The CEO-Employee Pay Ratio – Introduction
Pay disparity within organizations has been the subject of academic inquiry for decades. Two competing models – tournaments and equity fairness – have emerged that predict opposite effects of pay disparity. The issue has also triggered considerable public debate, particularly in recent years with claims that pay disparity has been rapidly increasing.1 Widely-reported estimates suggest that the compensation of Chief Executive Officers (CEOs) was about 20 times as much as the typical worker in the 1950s, rising to 42-to-1 in 1980 and 120-to-1 in 2000. The ratio now stands at 204-to-1 for the S&P 500, with the average of the top 100 companies at nearly 500-to-1 (e.g., Smith and Kuntz, 2013).
The debate came to a head on September 13, 2013 when a divided Securities and Exchange Commission (SEC) voted 3-2 to issue a proposed rule that would require most companies to disclose the annual total compensation of the median employee, the annual total compensation of the CEO (which is already available under existing compensation disclosure rules), and the ratio of CEO-to-employee pay (i.e., the pay ratio).2 The SEC observes in its proposal, however, that currently “it is not possible to quantify the usefulness to investors of company-specific pay ratio information” because most companies do not track or disclose compensation information for their workforce (SEC, 2013, p. 97).
A few companies voluntarily disclose some form of a pay ratio.3 About 10% of all U.S. firms disclose total compensation expense (Ballester, Livnat, and Sinha, 2002) which can be used in conjunction with other disclosed information to estimate a pay ratio (e.g., Faleye, Reis, and Venkateswaran, 2013). We note, however, that SEC rules require bank holding companies to separately report total compensation expense.4 Tis paper leverages the unique compensation data available for the banking sector to provide some of the first large sample, company-specific evidence on CEO-employee pay ratios and their relation to subsequent firm performance, risk, and shareholder advisory votes on executive compensation packages (i.e., “say on pay”).
Our sample consists of 10,581 observations for the period 1995-2012. For the vast majority of firms in the sample, pay ratios are substantially lower than the levels popularized in the financial press and policy debate. In fact, the mean (median) ratio of 16.58 (8.38) is well within the upper bound of 25-to-1 suggested by Drucker (1977). At the 90th percentile, the pay ratio is still a relatively moderate 32.86. Within the top decile, however, pay ratios rise rapidly to a maximum of 821.17. These findings stand in stark contrast to widely-publicized prior statistics which include only the largest companies in the economy (typically the S&P 500). By examining panel data with wide variation in firm size, we provide important new evidence on the magnitude and empirical distribution of pay ratios.
Tournament theory posits that pay disparity improves firm performance because it provides incentives for employees to exert effort to achieve promotion and the accompanying increase in pay (e.g., Lazear and Rosen, 1981; Green and Stokey, 1983). To maintain incentives throughout the organizational hierarchy, the size of the reward must be increasing at each stage in the tournament, with an extra reward for the overall winner (i.e., the CEO) (Rosen, 1986).
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