Companies with closer CEO pay ratios may generate higher profit per worker

Rob Friedman | E+ | Getty Images
Rob Friedman | E+ | Getty Images

For decades, publicly traded companies have disclosed their CEO pay. And ever since, they've been dogged by criticism that the pay is often not justified by the company's performance.

Starting this year, those companies also have to disclose their median worker's pay, as well as the ratio between that worker's compensation and the CEO's.

Firms have taken heat for the high multiples that top executives earn compared with their employees. But does the ratio also say something about performance?

A CNBC analysis of CEO pay ratios suggests that companies with more equal pay distribution also tend to generate higher profit per worker.

Prior academic research also suggests a performance penalty for unexplained differences in pay — that is, discrepancies that can't be explained by labor market economics. Ethan Rouen, an assistant professor at Harvard Business School, explored the phenomenon in his 2017 dissertation.

The reason may have to do with the impact that unfair pay has on workers, Rouen says. Workers may quit, for instance, or lack motivation if compensation is seen as unfair.

"Nobody expects to make as much as the CEO, but they expect to be paid fairly," he says.

Executive compensation more generally has been assailed for the apparent lack of correlation with performance. An MSCI analysis of hundreds of U.S. companies found that CEO pay totals were "poorly aligned" with performance over a 10 year period.

Urging caution

When U.S. companies disclosed the CEO pay ratio for the first time, many had a message to investors: Pay no attention.

Firms have warned that the CEO pay ratio — a requirement that was born out of the Dodd-Frank Act — shouldn't be used to compare different companies.

The ratios can vary depending on factors like the company's size, geographic distribution and percentage of part-time or seasonal workers. Companies also make decisions in how they calculate the ratio that affect the final outcome.

Experts also urge caution around reading too much into the ratio. "As an investor, I'd be hesitant to draw any conclusions from the raw number," Rouen says.

A report by advisory firm Willis Towers Watson found that companies take a range of approaches toward measuring compensation, making direct comparisons difficult. And a third of companies exclude some foreign workers from the calculation using what's known as the de minimis exemption.

Large discrepancies in pay crop up in some industries more than others — for example, retailers with many part-time workers have higher ratios than financial firms. Company size can also have a distortionary effect since CEOs at very large firms command outsize compensation, says Rouen.

In issuing the rule, the SEC explicitly stated that the purpose of the ratio was not "to facilitate comparisons." Given that, investors may well wonder what to do with it.

Brian Blackwood, an executive compensation consultant at Willis Towers Watson, says that investors are still "most keenly interested in what the pay for performance structure looks like," rather than how that CEO compensation relates to worker pay.

"The investors who will find the most value are those who have concerns about inequality," says Ric Marshall, executive director of ESG research at MSCI.

Managing worker morale

For companies, Blackwood says, the main concern is how employees will react to ratios that are in most cases exceedingly high.

"The disclosure isn't going to look good no matter what," says Rouen. "Most shareholders probably hope that most employees don't see this information."

Blackwood says that some firms are trying to use the ratios as an opportunity to start discussions around employee value. Proponents of the disclosure requirement say that more transparency should help to boost the pay of typical workers and curtail excessive pay to executives.

The goal for many advocates is to raise median wages and move companies closer in line with historic ratios. Back in 1965, the average CEO-to-worker pay ratio was 20-to-1, according to a report by the Economic Policy Institute. By 2013, the figure had grown to 296-to-1.