Last year, the average S&P 500 CEO's pay was $13.5 million in total compensation, or 373 times the annual pay of the average American worker. That ratio provided by the AFL-CIO is thought-provoking, if not infuriating, to many typical Americans. However, investors should tune in, too, and soon, they will have a more specific metric to gain perspective about the companies they own themselves.
Last week, the Securities and Exchange Commission finally issued a long-delayed rule requiring individual companies to disclose the pay ratio of their chief executives versus their own workers' pay. This rule was part of the Dodd-Frank Act, but business interests railed against the mandate for years.
Soon, we investors will have a new, customized ratio representing an extra factor to consider when we conduct our analyses and choose stocks for our own portfolios.
Why should shareholders care?
Many investors shrug about CEO pay, citing arguments like "market rates" for top talent and some vague idea of "merit," but at the end of the day, CEOs are paid with shareholder money so it deserves more than just a cursory shrug.
Some chief executives receive astronomical pay even when their companies' financials are dragging and their stock prices have suffered. CEOs are also employees, and too often "meritocracy" isn't measured by their actual performance. Anyone who's suffered through protracted losses from a company whose CEO makes astronomical sums probably understands the idea that pay doesn't always segue well with actual performance. Some studies back up the fact.
Last October, a study conducted by the University of Utah, Purdue University, and University of Cambridge found a negative correlation between highly paid CEOs and three years' worth of stock returns. According to the authors, "Our results appear to be driven by high-pay related CEO overconfidence that leads to shareholder wealth losses from activities such as overinvestment and value-destroying mergers and acquisitions."
On the other hand, a study by Towers Perrin last year took a look at the 50 highest-performing companies in the S&P 1500 over 15 years, and found those companies' CEOs were actually paid less than the market median. (Note that their realizable pay over time was higher due to bonuses like options and other incentives.)
Meritocracy for whom?
Given such signs that CEOs may be less subject to "meritocracy" in their pay schemes than regular Americans whose pay hasn't been increasing at an astronomical rate, the ratio will help us weigh the issue on a lot of different levels. The information will offer an angle through which we can gauge potential positives or negatives in workforce morale and internal business strength. Whether companies have healthy or toxic cultures can make a real difference in employees' performance -- and therefore, that of businesses as a whole.
Most human beings don't flourish in the face of unfairness. Pushing for productivity and company profits while getting the sense those efforts pad someone else's massive paychecks isn't very inspiring, much less the key to loyalty, for many employees.
The late Peter Drucker, long considered one of the foremost management experts, famously contended that employee morale starts to deteriorate when a company's CEO-to-worker pay ratio exceeds 20-to-1.
Once public companies start disclosing their ratios en masse in 2018, we'll be able to look at each and separate the "reasonable" from the potentially morale-bustingly "outrageous."
The race to the ratio
Some companies won't have to fret about anything publicly "embarrassing" about the new disclosure mandate. Their CEOs already have low compensation. To wit, Whole Foods Market (NASDAQ:WFM) is actually a voluntary vanguard, as it caps its executives' compensation at just 19 times that of its average workers' salaries and has had caps in place for nearly 30 years.
NorthWestern Corp. (NASDAQ:NWE) (more commonly known as NorthWestern Energy) has disclosed its ratio since 2010: a Drucker-esque 24-to-1.
Noble Energy (NASDAQ:NBL) has gone ahead and disclosed the data before the SEC's recent move. Charles Davidson, who was chairman and CEO until October 2014, made 82 times that of the company's median annual employee compensation in its proxy statement released in March. Compensation for now-CEO David Stover, who took over the CEO position in October, was 47-to-1 for that year.
We can expect that more companies to get ahead of the curve; one might anticipate that the ones with the most reasonable ratios might be more likely to go ahead and disclose. And, of course, some companies may have a little bit more to feel nervous about, according to numbers crunched by some outside firms.
For example, Bloomberg revealed that according to its calculations, last year McDonald's (NYSE:MCD) former CEO Don Thompson made 644 times that of the average McDonald's employee, who brought home about $11,000 compared to Thompson's total $7. 3 million in annual compensation.
That glaring discrepancy is interesting to contemplate given controversy about the fast-food giant's employee treatment and general concern about living wages. Meanwhile, shareholders can worry about low employee morale as well as ponder the fact that McDonald's business struggled during Thompson's tenure.
Analyzing a crucial stakeholder
Some proponents argue this ratio will work to bring CEO pay back down to earth. Personally, I'd like to see an end to outsized pay and a dedication to pay for performance.
I'd also like to see more investors wonder if high pay -- and pay discrepancies -- indicate companies that are too dangerously management-centric; after all, is the chief executive officer the most important stakeholder in any business? Are they more important than you as a shareholder, for example?
Last but not least, the ratio can help us start to consider the health of one of the most important stakeholders in any business, because without them, nothing runs: employees. When they're not happy, a company's risks begin to ratchet up, so investors, take note, and set your calendar for the CEO-to-worker pay ratio.
Check back at Fool.com for Alyce Lomax's columns on environmental, social, and governance topics.