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CEO Pay, Employee Pay, and Pay Inequality in Organizations: Meritocracy or Monkey Business?

February 25, 2019

 

The Guardian article by Sarah Anderson and Sam Pizzigati about runaway CEO pay is jarring.  

 

“The CEO of Marathon Petroleum, Gary Heminger, took home an astonishing 935 times more pay than his typical employee in 2017.  In other words, one of Marathon’s gas station workers would have to toil more than nine centuries to make as much as Heminger grabbed in just one year.”[1]

 

9 Centuries.

 

The average CEO earned 312 times the pay of their average employee in 2017.[2]  While Marathon seems like an outlier, they aren’t; the problem is endemic in corporate America.[3]  The British have their own way of calling attention to this problem.  The High Pay Centre think tank declared Wednesday, January 4th, 2017 as “Fat Cat Wednesday.”  This is the day executives passed the average UK worker salary. 

 

 

SEC Section 953(b) - The “Coming Out Party” for Pay Inequality

 

In 2018, companies in the US began reporting the ratio of CEO pay to average (median) employee pay under a new SEC rule mandated by the 2010 Dodd-Frank financial reforms.  The rule was enacted to give investors and employees insight into whether pay within a company is fair.  Companies weren’t thrilled about sharing this information, which is why it took 7 years to implement.[4]  This reporting has elevated the statistical concept of variation (or dispersion as economists refer to it) to the forefront of corporate governance and compensation, and there is a growing body of scientific research on pay dispersion and its effects.  Concern about pay inequality has also taken center stage in the broader press with discussions of the income gap between the rich and the poor.  While many aspects of this topic are hotly debated, most writers paint a pessimistic picture--a widening gap in most developed countries with dire risks and consequences for both the winners and the losers.[5]

 

And there is increasing evidence these two are connected, that increasing pay inequality within companies may be contributing to the widening income gap between the rich and the poor.  A large team of researchers from the Social Security Administration and several top universities conducted an extraordinary study, tracking every company and every employee in the US from 1978 to 2013.[6]  Their results confirmed pay inequality is growing and the growth is caused by increasing pay inequality both between and within companies.  This means some companies are getting richer while others are getting poorer (in terms of the average wages of their employees) and some employees within companies are getting richer while others are getting poorer.  Growth in between-company pay inequality seems to be the bigger problem, likely caused by shifts in workforce composition and increased use of contractors and outsourcing.  However, growth in within-company pay inequality still accounted for a substantial 31% of the growth in pay inequality among all firms and 42% among larger firms (>10,000 employees).  This means individual companies are holding a non-trivial piece of the pay inequality burlap and their pay practices are contributing to growth in income inequality on a larger scale.

 

 

Will Anyone Care? 

 

Those behind Dodd-Frank and the new SEC rule hope disclosure of this information will be a wake-up call to companies.  They hope investors will care about how companies pay their employees and put pressure on them to reduce pay inequality (or face the prospect of losing investors).  But a year into the reporting, companies are relieved to hear…almost nothing.[7]

 

Will investors care?  The popular sentiment at this point is probably not; investors care about earnings.  And even if they did care, they need better information than what is being required by the SEC rule.  There are many factors that affect the ratio of CEO to average worker pay that have little to do with the fairness of pay within a company (e.g. the composition of the workforce within a company).[8] And while companies certainly care about unwelcome noise about pay, most aren’t likely to be too concerned about pay inequality since they see it a natural consequence of meritocracy.[9]  Inequality in pay, the economically rational argument goes, is caused by legitimate factors--real differences in the skills, performance, and value contributed by workers.  In economic language, pay differences reflect differential inputs and marginal products.   These arguments go further, suggesting rewards must be unequal to motivate employees.  This is a core principle of tournament theory, one of the “mother theories” behind modern compensation practices.  High levels of pay inequality are necessary to motivate employees to work hard and climb the corporate ladder.[10]

 

Should investors and others care about increasing pay inequality within companies?

 

Yes, they should.

 

They should care because conventional, economically rational arguments do not necessarily serve us well here.  There is a large body of scientific evidence on this topic and it does not show that companies with higher CEO-worker pay disparities and higher pay inequality are more successful.  In fact, they are frequently less successful (although this research isn't definitive).  And there is good reason to suspect the pay inequality we see within companies isn’t caused only (or even mostly) by legitimate factors.[11]  And even if companies don’t pay attention to scientific research, they should still care. The prospect of people taking to the streets is real.  There have been many protests of the gender wage gap and protests like the yellow vests in France are motivated in part by the harm being done to working class workers by tax reforms and other initiatives.  And legislators are already beginning to take matters into their own hands, regulating or taxing offenders.[12]

 

 

The Case for “Non-Legitimate” Pay Inequality

 

Ethan Rouen a researcher from Harvard Business School recently put economically rational arguments to the test in a study of CEO-to-average-worker pay disparities among 931 firms in the S&P 500 from 2006 to 2013.[13]  Rouen identified a number of factors that might legitimately affect these disparities without signaling any unfairness (e.g. economic, structural, organizational, and workforce composition factors).  For example, firms with lots of retail jobs will have higher pay disparities because retail workers are typically paid less, pulling down average employee pay.  Kohl’s, Inc. for example has a CEO-to-average worker pay ratio of 1,264:1. The opposite happens in firms with lots of R&D workers who tend to be paid more.  Pharmaceutical company Merck & Company for example has a CEO-to-average worker pay ratio of 215:1.  You can begin to see the flaws with this ratio as an indicator of pay unfairness. Rouen used a number of these legitimate factors to calculate an expected(predicted) CEO-to-worker pay ratio which he called the “economic pay ratio” (the ratio explained by the “economics” of the business).  He then subtracted this ratio from the reported pay ratio, calling this remainder the “unexplained pay ratio.”  This represents the ratio not explained by the legitimate economics of the business and could reflect the influence of factors unfairly contributing to pay inequality. 

 

Rouen’s results showed that pay disparities can be either helpful or harmful depending on whether they are caused by legitimate or non-legitimate factors.  Companies with higher economic pay ratios performed better (based on a number of financial measures) and their employees fared better (e.g. higher satisfaction and retention).  Companies with higher unexplained pay ratios on the other hand had poorer performance and employee outcomes.   Results from other studies are consistent with these findings.[14]  Rouen’s study also disconfirmed the conventional economic wisdom that pay disparities are mostly caused by legitimate factors.  In his study, 39% of the variation in CEO pay and 42% of the variation in employee pay could not be explained by legitimate factors.  These are big numbers and they suggest there is almost certainly “monkey business” happening in organizations unfairly contributing to pay inequality.

 

 

Variable Pay:  A Prime Suspect?

 

While there may be lots of non-legitimate factors influencing pay inequality in organizations (gender has been an important one receiving much attention lately), variable pay programs are almost certainly a key contributor.  Merit pay, bonus pay, and other individual incentive programs are designed to create pay inequality.  These programs explicitly differentiate individual rewards.  Variable pay accounts for a significant amount of the growth in pay inequality, especially for higher wage earners, where it can account for up to 70 or even 80 percent of total pay.[15]  And variable pay is becoming a larger percentage of total pay and for more people (at least in the US).[16]  These programs are becoming staples in organizations and most of us see this as a positive trend; variable pay is widely seen as a legitimate factor contributing to pay inequality.  What could be more legitimate than “pay for performance?”  It’s clear from research evidence however the way these programs create pay inequality isn’t always legitimate or fair.  Just ask employees.  Surveys show many employees don’t feel rewards are distributed fairly and don’t feel they are based on appropriate criteria…performance for example.  Those in charge of these programs are equally downbeat.  Few of them say their programs are effective at differentiating rewards based on individual performance and driving higher performance.  Companies don’t tinker with or overhaul their programs every few years if they are happy with them.[17]

 

And research from psychology, management and economics validates our dissatisfaction and frustration with these programs.  While studies show these programs can work in certain circumstances, they are not the motivational and productivity-improvement panaceas many claim. These programs don’t broadly lead to better company outcomes--performance, productivity, retention, and innovation, or employee outcomes--engagement, satisfaction, and performance.  And we have all seen the headlines documenting what happens when employees “get creative” with these programs (Wells Fargo’s recent experience comes to mind).  Even when they “work”, they can have unforeseen consequences and unexpected side effects that can be worse than the disease they are designed to treat.[18]  And variable pay programs for senior leaders have not fared any better.  Researchers have strongly criticized the use of these programs for top management and CEO’s and cite a number of problems associated with their use.[19]

 

One important way these programs unfairly affect pay inequality is that many of them base reward decisions on subjective performance evaluations by supervisors.  Pay for performance in most companies means “pay for performance ratings,” and behavioral science research has shown these ratings are fraught with problems that make them unsuitable for such use.[20]  Researchers agree these ratings tell us far more about the supervisors doing the evaluations (and their biases, idiosyncrasies and motives) than they tell us about the performance of the employees being evaluated. 

 

So, if companies are concerned about unfair pay inequality and its effect on their employees and organization, they should start with a review of these programs.  My advice (and the advice of other experts who are critical of these programs) is to dramatically scale them back or eliminate them entirely.

 

That’s right…eliminate them.

 

Now I’m not naïve; I realize the prospect of eliminating variable pay programs can be terrifying to those of us who grew up thinking this was how you manage performance and motivate employees.  And tax laws governing pay for top officers of a company will certainly make this challenging at the top.  But the harsh reality is you may be getting amazing results from your employees despite these programs not because of them.  One estimate puts the price tag of these programs at $345B per year in the US alone, and this doesn’t include the time and money to design and redesign them or the costs of developing and maintaining the systems necessary to track and report performance.  This is a huge investment and it is sobering to think it may not be helping and may even be hurting employee and organizational performance.

 

There are more effective ways to motivate employees without these programs and you can still manage compensation effectively.  And the net effect would be to reduce the influence of non-legitimate sources of pay inequality.  Companies should think separately about motivating employees and managing compensation. Here are some actions you can take to effectively address each of these 2 elements.

 

Manage Compensation

  • Focus on base pay and external market relativity instead of internal competition.  Pay employees what they are worth in the market and pay your critical talent above market.  Pay the person instead of the job.

  • Grow employee pay over time with market-based adjustments and cost-of-living increases.  Raise employee pay by promoting them more frequently.  Go back to narrow-banded job structures that allow for more frequent promotions.  Give employees something to look forward to.

  • Share the wealth.  Replace individual variable pay programs with team and organizationally-based programs like profit sharing, gain-sharing, and stock ownership.[21]  These programs work and don’t have the problems associated with individual variable pay programs. 

  • Continue to take care of your top talent and high potentials in other ways, with faster promotions, special leadership development programs, challenging assignments, and other investments in their growth.  

  • Aggressively manage poor performance.  Abandoning traditional variable pay programs doesn’t mean you don’t need to manage performance.  Implement a performance improvement process for employees who are in trouble.

 

Motivate Employees 

  • Align the work of employees with important team, organization, and company goals.  Ensure they have line of sight between their day-to-day work and how their work benefits the organization, its customers and other stakeholders.  Help them see the larger meaning behind their efforts.

  • Make regular employee-supervisor interactions more about facilitating progress toward meaningful goals and less about monitoring, surveillance, and corrective feedback.  It is progress that motivates employees, not feedback (which is predominantly negative). Teach supervisors to use positive feedback to support employee progress.

  • Leverage the power of others to motivate employees.  Work is increasingly a “team sport.”  Take advantage of this.  People have a deep-seated need to belong and they will work hard to achieve important goals shared by their coworkers.  They don’t want to let their teammates down.[22]

  • Use the work people do every day to motivate.  Employees want important, challenging work to do.  Give it to them and give them the discretion and autonomy to craft their own jobs, which benefits them and the organization.  Train your supervisors how to use work and jobs to motivate.

 

Reporting CEO-to-average-worker pay ratios is bringing attention to the possibility of unfair pay inequality in organizations, and this scrutiny will only intensify as investors, the media and other stakeholders digest this data.  You can fight it, you can try to explain it away, or you can wait until employees, shareholders, regulators, and policy makers raise more red flags and demand or even legislate action.  Or, you can accept it may be hurting your business and your employees and start to address it now.  What are you waiting for?

 

(This article benefitted from very helpful feedback from Ethan Rouen from Harvard Business School).

 

 

 

End Notes

 

[1]Anderson, S., & Pizzigati, S. (2018).  No CEO should earn 1000 times more than a regular employee.  The Guardian, March 18.  

 

[2]Mishel, L., & Schieder, J. (2018).  CEO compensation surged in 2017.  Economic Policy Institute report.

 

[3]For example, the CEO of Manpower took home a staggering 2,483 times more pay than their average employee in 2017.  Bloomberg

 

created a tracker for companies in the Russell 1000 and the S&P 500 so you can look up your favorite company.  You can find it here: https://www.bloomberg.com/graphics/ceo-pay-ratio/

 

[4]For context, see the letter from Senator Bob Menendez to the head of Securities and Exchange Commission (and signed by several other Senators) dated March 21, 2017, urging them to “get on with it.”

 

[5]The citation most associated with the widening of the wage gap is Piketty, T., &  Emmanuel, S. (2003). Income Inequality in the United States, 1913-1998.  The Quarterly Journal of Economics, 118, 1–39.  The authors have also written more contemporary accounts with some methodological changes:  Piketty, T., Emmanuel, S., & Gabriel, Z. (2018).  Distributional national accounts:  Methods and estimates for the United States.  The Quarterly Journal of Economics, 131, 519–578.  Another good reference is:  Deutsche Bank (2017).  US inequality.  white paper. August 2017.

For a dissenting opinion on the extent of growth in income inequality, see: Auten, G., & Splinter, D. (2018).  Income inequality in the United States:  Using tax data to measure long-term trends.  White paper.

 

[6]Song, J., Price, D. J., Guvenen, F., Bloom, N., & von Wachter, T. (2016).  Firming up inequality.  National Bureau of Economic Research, working paper No. 21199.

 

[7] For example, see:  Podstupka, S. (2018).  The sound of comp silence.  Workspan.  November/December.

 

[8]There are a number of authors who have detailed problems with this measure.  See the following for example:

Rouen, E. (2017).  Rethinking measurement of pay disparity and its relation to firm performance. Harvard Business School working paper 18-007.

Edmans, A. (2017).  Why we need to stop obsessing over CEO pay ratios.  Harvard Business Review Online, February 23.

 

[9]There are certainly exceptions.  Many companies have taken a public stand on gender-based pay inequality and have proactively raised wages among lower-level employees (e.g. Walmart, Aetna, Salesforce, Reddit, and many others).  For more on this trend and the consequences of not addressing it, see:  Wartzman, R. (2017). Aetna CEO:  Capitalism will suffer “death by a thousand cuts” if income inequality persists.  Fast Company, October 3.

 

[10]For an overview of tournament theory, see Connelly, B. L., Tihanyi, L., Crook, T. R., & Gangloff, K. A. (2014). Tournament theory: Thirty years of contests and competition. Journal of Management, 40, 1, 16-47. 

 

[11]For reviews of this research literature, see:

Shaw, J. (2014). Pay dispersion.  Annual Review of Organizational Psychology and Organizational Behavior, 1, 521-544.

Mahy, B., Rycx, F., & Volral, M. (2011). Does wage dispersion make all firms productive?Scottish Journal of Political Economy, 58, 455-489.

 

[12]Anderson, S., & Pizzigati, S.  (2019). When corporations pay CEOs way more than employees, make them pay.  The Nation.  January 17.

 

[13]Rouen, E. (2017).  Rethinking measurement of pay disparity and its relation to firm performance. Harvard Business School working paper 18-007.

 

[14]Jason Shaw reviews other studies that look at the impact of legitimate and non-legitimate pay disparity in his review of pay dispersion research.  See Shaw, J. (2014). Pay dispersion.  Annual Review of Organizational Psychology and Organizational Behavior, 1, 521-544.

 

[15]For more background on pay for performance, pay inequality, and CEO pay, see:

Lemieux, T., 2008.  The changing nature of wage inequality. Journal of Population Economics, 21, 21-48.

Trevor, C., Reilly, G., Gerhart, B., 2012.  Reconsidering pay dispersion’s effect on the performance of interdependent work: Reconciling sorting and pay inequality. Academy of Management Journal, 55, 585-610.

Larker, D. F., & Tayan, B. (2015). CEO Compensation. Stanford University, Corporate Governance Research Initiative.  

 

[16]Miller, S. (2014).  Variable pay spending spikes to record high.  SHRM, September 2014.  (Citing research by Aon Hewitt:  US Salary Survey 2014).

 

[17]For statistics on pay for performance and variable pay programs, see the following reports:

Mercer (2017).  Getting it Right:  Salary and Performance Management Reboot.  Compensation Planning and Performance Management Webcast:  

Hudner, J., & Oliver, K. (2013). Current trends and new directions in variable pay. Working Report, Pearl Meyer & Partners, 2013.  

For statistics on variable pay for CEOs, see:

Marshall, R. (2017).  Out of whack:  US CEO pay and long-term investment returns.  MSCI white paper.

For statistics on how employees feel about their pay and variable pay, see:

Willis Towers Watson (2016).  Pay for Performance:   Time to challenge conventional thinking.  February 2016:

SHRM (2016).  Employee job satisfaction and engagement:  Revitalizing and changing workforce.  Research report.

Payscale (2016).  Escape to Comptopia:  2016 Best practices report.  Research report. 

 

[18]For a review of this literature, see Colquitt, A. L. (2017).  Next Generation Performance Management:  The Triumph of Science over Myth and Superstition.  Charlotte:  Information Age Publishing.  Chapter 5-6.

Below are other selected readings and reviews of the pay-for-performance literature:

Manzoni, J. F. (2008).  On the folly of hoping for A, simply because you are trying to pay for A.  Studies in Managerial and Financial Accounting, 18, 19-41.

Kerr, S. (1975). On the folly of rewarding A, while hoping for B.  Academy of Management Journal, 18, 769-783.

Pfeffer, J., & Sutton, R. I.  (2006). Hard facts, dangerous half-truths and total nonsense:  Profiting from evidence-based management.  Boston:  Harvard Business School Press.

Pfeffer, J.  (1998). Six dangerous myths about pay.  Harvard Business Review.  May-June, 109-119.

Pink, D. H. (2009).  Drive:  The surprising truth about what motivates us.  New York:  Riverhead Books.

Beer, M., & Katz, N.  (2003). Do incentives work?  The perceptions of a world-wide sample of senior executives.  Human Resource Planning, 26, 30-44.

Beer, M., & Cannon, M. D. (2004). Promise and peril in implementing pay-for-performance.  Human Resource Management, 43, 3-48.

Gneezy, U., Meier, S., & Rey-Biel, P. (2011). When and why incentives (don’t) work to modify behavior.  Journal of Economic Perspectives, 25,1-21.

Colquitt, A. L. (2015).  A pleasant death of performance-based pay.  HR People + Strategy, August 31.

 

[19]For research on pay for performance at the CEO and top management level, see:

Lorsch, J., & Khurana, R. (2010).   The pay problem.  Harvard Magazine.  May-June.

Cable, D., & Vermeulen, F. (2016).  Stop paying executives for performance.  Harvard Business Review Online, February 23.

Dorff, M. B. (2014). Indispensable and other myths:  Why the CEO pay experiment failed and how to fix it.  Los Angeles:  University of California Press.

 

[20]Adler, S., Campion, M., Colquitt, A., Grubb, A., Murphy, K., Ollander-Krane, R., & Pulakos, E. (2016).  Getting rid of performance ratings:  Genius or folly—a debate.  Industrial and Organizational Psychology, 9, 219-252.

 

[21]For a nice overview of the research support for these programs, see:  Kruse, D. L., Freeman, R. B., & Blasi, J. R. (2010). Shared capitalism at work: Employee ownership, profit and gain sharing, and broad-based stock options. National Bureau of Economic Research conference report. Chicago: University of Chicago Press.

 

[22]If you want to read more about these strategies and the thinking behind them, here are some places to start:

Hurst, A. (2016). The purpose economy.  Boise: Elevate Publishing.

Pink, D. H. (2009). Drive: The surprising truth about what motivates us.  New York: Riverhead Books.

Amabile, T., & Kramer, S. (2009).  The progress principle: Using small wins to ignite joy, engagement and creativity at work. Boston: Harvard Business School Press.

Rosso, B. D., Dekas, K. H., & Wrzesniewski, A. (2010). On the meaning of work: A theoretical integration and review.  Research in Organizational Behavior, 30, 91-127.

Hackman, J. R., & Oldham, G. R. (1980). Work redesign.  Addison-Wesley: Reading, MA.

Losada, M., & Heaphy, E. (2004). The role of positivity and connectivity in the performance of business teams: A nonlinear dynamics model. American Behavioral Scientist, 47, 740-765.

Baumeister, R. F., & Leary, M. R. (1995). The need to belong:  Desire for interpersonal attachments as a fundamental human motivation. Psychological Bulletin, 117, 497–529.

Kruse, D. L., Freeman, R. B., & Blasi, J. R. (2010). Shared capitalism at work: Employee ownership, profit and gain sharing, and broad-based stock options. National Bureau of Economic Research conference report. Chicago: University of Chicago Press.

Rudolph, C. W., Katz, I. M., Lavigne, K. N., & Zacher, H. (2017).  Job crafting: A meta-analysis of relationships with individual differences, job characteristics, and work outcomes.  Journal of Vocational Behavior, 102, 112-138.

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