Top Executive Pay Does Not Reflect Market Forces

The compensation and bonus packages of top executives are an ongoing source of public concern and outrage. The intended 50% increase for ING-Banking CEO Hamers was quickly reversed after Dutch politicians had publicly announced this would be unacceptable. At Unilever, shareholders expressed concern about plans that would triple the total compensation for CEO Polman. These huge increases for top-level managers –who already receive generous compensation- seem all the more out of proportion when compared to the pay levels of average workers in their company. This year’s requirement that public companies disclose their CEO-to-worker pay ratio revealed once more how large this gap is. It is difficult to make exact comparisons between different companies because the guidelines for calculating this ratio are not very specific. Nevertheless CEOs whose compensation is 100-300 times the median pay level in their company are not exceptional. This is even more difficult to swallow when the compensation for the CEO is increased, at the same time as regular workers are laid off or get paid less than before. This happened at Harpa Concert Hall in Iceland, where many members of the personnel resigned after their wages were reduced while the CEO received a 20% pay rise.

Economists and governance experts often justify such remuneration policies by referring to the large responsibilities top executives have to carry. They emphasize the complexity and importance of executive decisions which affect the success of the whole company. They explain that a large increase is necessary to make up for many years of reticence in the CEO’s compensation. They also remind us that it would not be possible to attract top talent in a free market without paying top wages.

Government policy makers reason differently. They are concerned about public accountability, and hope that top managers will feel embarrassed when it is revealed how much more than others they earn. Regulations that prescribe transparency are meant to achieve this, but so far seem rather ineffective.

Workers question the fairness and justice of such extreme compensation differences–which allegedly reflect differential efforts made on behalf of the company. They feel demotivated as they wonder whether the decisions of one person at the top can really be so much more important than everything that is achieved on the work floor.

The general public is stunned about the amounts of money these people earn. How much does a person need to lead a good life? Why should a single person earn so much money? Don’t these people ever have enough?

Obviously, all these parties view the situation from a different perspective. But who is right?

Researchers have tried to establish the forces that are really driving the disproportionate increases in top executive compensation. They did this by considering how CEO pay levels developed over time, and how this relates to other relevant variables. A study analyzing pay levels of top CEO’s between 1940 and 2005 in this way reveals that an explanation in terms of free market principles cannot account for the observed developments. Large increases in compensation rates do not occur at times when top managers are scarce. Lack of power in the board to resist CEO compensation requests is sometimes quoted as an alternative possibility to explain ever increasing pay levels. However, the data of this study show that CEO compensation only increased further as regulations afforded more control to the board of supervisors.

Other types of data additionally show how unlikely it is that the efforts or decisions of a single individual are decisive for the success of the company, as this also depends on a number of external factors outside the CEO’s control–including macro-economic developments. In fact, several studies have revealed how harmful large pay differences can be for company results, for instance because it elicits feelings of injustice that undermine work performance.

In view of the available data, the most plausible explanation for the continuous and extravagant pay increase for CEOs relates to their desire to show that they outperform other top managers. Further, supervisory boards tend to approve of high compensation levels as a way to communicate their confidence in the current management and their commitment to the CEO. These are not economic forces, but social forces driving top executive compensation to sky-high levels. Ironically, the power of such social forces is only increased when compensation levels and pay ratios are publicly revealed.

How to put a stop to this development? The easiest solution would be to simply connect rewards for top management to wage developments in the rest of the company. Just offer the same percentage increase that average workers receive. No compensation increase for top management when other employees don’t receive a pay rise. This offers an easy way to connect the compensation package for top managers to their success as employers, an outcome that is more revealing of CEO decisions than is the shareholder value of the company.