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The determinants and effects of CEO-employee pay ratios

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Last updated: June 18, 2013

(iStock)
(iStock)

In 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, requiring companies to disclose pay differentials in the form of CEO-Employee pay ratios, among various other reforms intended to better inform the American public about the activities of corporations and discourage behavior that could contribute to another financial crisis. Although the legal details of that mandatory disclosure remain in dispute, the pay disparity between CEOs and employees has drawn significant attention from the media and criticism from advocacy groups.

Because executive pay can have a variety of components, there are a number of different methods for calculating this ratio. The Economic Policy Institute notes that “the CEO-to-worker compensation ratio was 18.3 to 1 in 1965, peaked at 411.3 to 1 in 2000, and sits at 209.4 to 1 in 2011.”

In 2013 Bloomberg News estimated the ratio at 204 to 1, up 20% from 2009, across the Standard & Poor’s 500 Index of companies. In 2012, the AFL-CIO estimated the CEO-worker pay ratio to be 357 to 1. There is significant variation across companies, and while some have more modest ratios, some corporations have been called out for having ratios exceeding 500 to 1 or even 700 to 1. (For a look at the salary figures, see the New York Times2013 chart of the top 200 CEOs.)

CEO-to-worker compensation (Economic Policy Institute)

Despite the increased attention to the issue, limited research has been done on what determines this disparity or what its effect is on employee motivation and productivity. A 2013 paper by researchers at Northeastern University and Bentley University published in the Journal of Banking and Finance, “The Determinants and Effects of CEO-Employee Pay Ratios,” utilizes data on executive compensation from the Standard and Poor (S&P) ExecuComp database, and on employee compensation from CompuStat. (An open-access version of the paper is available at SSRN.) The authors, Olubunmi Faleye, Ebru Reis and Anand Venkateswaran, examine the relationship between relative pay, measured by the CEO-employee pay ratio, and employee productivity, measured by revenue per employee, taking into account various firm characteristics such as size, performance, board structure and other factors.

The study’s findings include:

  • Relative pay of CEOs, measured by the CEO-employee pay ratio, is strongly associated with variables that affect CEO bargaining power, chiefly firm size, performance and risk.
  • An increase in one standard deviation in firm size is associated with a 106% increase in the CEO-employee pay ratio. One standard deviation increases in market adjusted stock-return, operating performance, and firm risk, were associated with increases in relative pay of CEOs of 5%, 18% and 12%, respectively.
  • Variables related to greater employee bargaining power, such as unionization and greater physical capital intensity, were generally associated with lower relative pay for CEOs.
  • An increase of one standard deviation in employee unionization was associated with a 53% decrease in the CEO-employee pay ratio. A similar increase in physical capital intensity was associated with a 24% decrease in this pay ratio.
  • In general, the relationship between the CEO-employee pay ratio and firm productivity proves to be statistically insignificant, indicating that relative pay has no impact on the productivity of a firm’s employees.
  • Relative pay is significantly and positively related with employee productivity in smaller firms, with a one standard deviation increase in the CEO-employee pay ratio being associated with a 10.5% increase in revenue per employee for firms with fewer than 3,250 employees.
  • Firm value increases with higher relative pay for CEOs, with a one standard deviation increase in the CEO-employee pay ratio resulting in a 5.3% increase in firm value. Operating performance is also found to increase with higher relative pay for CEOs.

“These results suggest that observed pay ratios between top executives and ordinary employees arise mainly from the relative ability of workers and executives to negotiate higher compensation with the relevant counterparty,” the authors state. “Workers earn more and pay ratios are lower when ordinary employees enjoy relative strength in negotiating with management, for example, when the workforce is highly skilled or unionized and employees are not easily replaceable.” Furthermore, they find “a positive productivity effect in settings where tournament incentives are plausibly stronger, such as when the firm has fewer employees who are informed on executive pay or are not unionized.”

Tags: financial crisis, organized labor


Writer: | June 18, 2013

Citation: Faleye, Olubunmi; Reis, Ebru; Venkateswaran, Anand. “The Determinants and Effects of CEO-Employee Pay Ratios,” Journal of Banking and Finance, Vol. 37, Issue 8, August 2013, 3258-3272.

Analysis assignments

Read the issue-related BloombergBusinessweek article titled "CEO Pay 1,795-to-1 Multiple of Wages Skirts U.S. Law."

  1. What key insights from the news article and the study in this lesson should reporters be aware of as they cover these issues?

Read the full study titled “The Determinants and Effects of CEO-Employee Pay Ratios.”

  1. What are the study's key technical terms? Which ones need to be put into language a lay audience can understand?
  2. Do the study’s authors put the research into context and show how they are advancing the state of knowledge about the subject? If so, what did the previous research indicate?
  3. What is the study’s research method? If there are statistical results, how did the scholars arrive at them?
  4. Evaluate the study's limitations. (For example, are there weaknesses in the study's data or research design?)
  5. How could the findings be misreported or misinterpreted by a reporter? In other words, what are the difficulties in conveying the data accurately? Give an example of a faulty headline or story lead.

Newswriting and digital reporting assignments

  1. Write a lead, headline or nut graph based on the study.
  2. Spend 60 minutes exploring the issue by accessing sources of information other than the study. Write a lead (or headline or nut graph) based on the study but informed by the new information. Does the new information significantly change what one would write based on the study alone?
  3. Compose two Twitter messages of 140 characters or fewer accurately conveying the study’s findings to a general audience. Make sure to use appropriate hashtags.
  4. Choose several key quotations from the study and show how they would be set up and used in a brief blog post.
  5. Map out the structure for a 60-second video segment about the study. What combination of study findings and visual aids could be used?
  6. Find pictures and graphics that might run with a story about the study. If appropriate, also find two related videos to embed in an online posting. Be sure to evaluate the credibility and appropriateness of any materials you would aggregate and repurpose.

Class discussion questions

  1. What is the study’s most important finding?
  2. Would members of the public intuitively understand the study’s findings? If not, what would be the most effective way to relate them?
  3. What kinds of knowledgeable sources you would interview to report the study in context?
  4. How could the study be “localized” and shown to have community implications?
  5. How might the study be explained through the stories of representative individuals? What kinds of people might a reporter feature to make such a story about the study come alive?
  6. What sorts of stories might be generated out of secondary information or ideas discussed in the study?

 

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Why Colorado executive pay seems to defy gravity | Colorado News Feed Jun 30, 2013 12:54

[...] One approach to move executive compensate into viewpoint is to demeanour during it as a ratio of what a normal workman during a association makes, something a U.S. Securities and Exchange Commission is study per a Dodd-Frank Wall Street Reform and Consumer Protection Act. [...]

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