If a CEO makes an outrageous amount in compensation, what effect will comparing that salary to the average worker have? Perhaps not some of the intended results, like reining in top pay. In fact, such a ratio may show which companies don't sufficiently compensate their executives, giving managers greater leverage to demand even higher salaries. Why?
It's all about keeping up with competitors' salaries.
The coming law
Under the Dodd-Frank Act, the SEC by the end of the year will likely require disclosure of how CEO compensation compares to the company's average worker. The requirement comes at a time of great income disparity, both between high and low incomes and between labor and corporations. To sum up the argument for the mandate, Fool Alyce Lomax succinctly notes:
CEO pay at most American companies has careened out of control. Shareholders need to raise awareness of what is justifiable and how the best-paid CEOs are creating profits and at whose expense. Disclosing individual companies' CEO-to-worker pay ratio would give some much-needed perspective about corporate priorities.
Unintended consequences
James Surowiecki of The New Yorker writes that such a policy will only lead to even more drastic pay packages for CEOs. This is because many companies use a peer-group comparison to help determine salary. As companies compares themselves to others, they boost their CEOs' pay to show that their execs are worth more. And the cycle repeats, leading to ever-increasing pay.
For example, Intel's (INTC 3.60%) peer group to help determine its executive pay consists of 23 other companies, which range from $16 billion in market capitalization to $400 billion. Of these 23 companies, 13 were in the tech sector. Does it make sense to determine pay through comparisons with businesses that have completely different scale and economics? Perhaps, if Intel needs to compete with these companies for talent. On the flip side, despite Intel's relatively poor stock performance over the past three years, its past CEO Paul Otellini made $15.6 million for 2010, $17.5 million in 2011, and $18.9 million 2012.
As Intel stated in its proxy statement, "The Compensation Committee evaluates total direct compensation against the 50th to 65th percentile of our peer group ... to provide flexibility to attract and retain the best people for our business." Intel does not want to appear stingy when it comes to the most important post of the company, for the sake of attracting both talent and investors, which means it needs to match or exceed its peer group. This leads to the aforementioned cycle of peer-group compensation building upon itself.
A new, easy-to-understand measure of how much a CEO is worth to a company will only introduce another metric for companies to compare among themselves. If Intel aims to keep its CEO pay ratio above its peer group, compensation will only rise.
Will investors care?
The only way such a CEO-to-worker pay ratio could help rein in outrageous CEO pay is if investors pay close attention to the numbers and only invest in companies that keep compensation rational. In a list of qualities investors look for, like a potential growth story or value, the CEO-to-worker pay ratio will likely be far from the top. And, especially for large-cap companies, the extra millions that go into the CEO's pocket can be rounding errors on the final profit. For such companies, looking cheap when hiring might seem much worse than an outrageous pay ratio.
