Fairness matters. Pay ratios don’t.

Executive Pay

20 Apr

20 April 2020

The focus should be on how companies treat their employees not on the largely meaningless pay ratio statistic

Pay ratio disclosure is with us

Just before COVID-19 hit us, I was a panelist at an event on pay ratios run by The High Pay Centre in conjunction with the Standard Life Foundation. Titled What will pay ratio reporting mean? Will it change anything? the event marked the mandatory disclosure of pay ratios for UK listed companies, effective for 2019 remuneration reports which are now being released at the start of 2020.

The debate was characterised by a number of implicit assumptions (or at times explicit assertions) that are often made in the debate on executive pay:

Inequality is increasingly a problem.
Lower pay ratios will create a win-win of a more workers and higher performance.
Therefore, we should be aiming to reduce CEO pay ratios.

My focus in this blog is mainly on the second of these assertions, which too often goes unchallenged, given that rigorous academic evidence largely contradicts it.

The impact of pay inequality on company performance is not self-evident

It is often said that high pay demotivates employees. In their report Executive Rewards: Paying for Success the UK Parliament's BEIS Select Committee state that: 'Huge pay awards, and pay inequality in general, can only contribute to disengagement by employees'. A commonly cited survey is one carried out by the CIPD in 2015, which found that 60% of respondents agreed that CEO pay levels in the UK demotivate employees. The conclusion from this is that the demotivation of employees will lead to lower performance, and that, by extension, reducing pay inequality will increase motivation creating a win-win of more equal, higher performing companies.

Opinion poll results based on tendentious questions are notoriously unreliable, with respondents quite capable of giving contradictory answers within the same survey. But even if we take these results at face value, what employees say could be quite different from what they do. My participation in the panel caused me to revisit some of the academic evidence on this point. Fortunately we have good studies available that look at the impact of pay inequality on companies in the US, UK, and Germany. Empirical studies are important in this area because it is possible to create plausible hypotheses as to way pay inequality within firms is negative, positive, or neutral to performance:

It could be, as alleged by the CIPD survey, that pay inequality within a company demotivates employees who therefore work less hard or are less productive.
Or, it could be that pay inequality helps companies to recruit the best management talent and encourages employees to strive for promotion, improving performance.
Or, it could be that employees take no notice of pay inequality, and that pay is irrelevant to the recruitment of talented managers, so that there is no impact on performance (or positive and negative impacts could cancel out).

Which of these hypotheses is correct is entirely an empirical question, but unfortunately is normally taken as being a self-evident truth, whichever side of the argument the protagonist is on.

Studies on pay inequality

In their 2013 paper in the Journal of Banking and Finance Falaye, Reis and Venkateswaranlook look at the impact of pay inequality on a range of company productivity and performance metrics in the US over the period 1993 to 2006. First they look at the impact on employee productivity, measured by revenue per employee, then they look at the impact on overall company performance including return on assets, price-to-book ratio, and shareholder returns.

The paper is worth a read in full, but in summary they find that:

Pay inequality in the company has no impact on employee productivity.
Pay inequality is positively and significantly associated with better operating performance measured by return-on-assets.
Pay inequality is positively and significantly associated with better market valuation metrics including price-to-book ratio, and total shareholder return.

Mueller, Ouimet and Simintzi at all carry out a similar analysis for the UK, published in The Review of Financial Studies. A public version of their paper can be found here. They study overall company performance rather than employee productivity. They have similar findings:

Pay inequality is positive and significantly associated with better operating performance measured by return-on-assets.
Pay inequality is positively and significantly associated with better market valuation metrics including price-to-book ratio, and total shareholder return.

Interestingly, the outperformance of high pay-inequality firms by reference to total shareholder return is driven by low inequality firms underperforming the norm, rather than high inequality firms out-performing.

To give comfort that this is not just an anglo-saxon finding, Dittmann, Montone, and Zhu carry out a very similar analysis to that undertake by Mueller et al but based on German data. This paper is currently unpublished but is available online as a pre-published version. As their techniques are quite similar to Mueller et al it is reasonable to consider their results as reliable, subject to the caveat that they still need to undergo peer review. They find almost identical results, although provide some further insight as to what is driving the outperformance in total shareholder returns, which they also find is driven by underperformance of low inequality companies.

Analysis of the investor registers of low and high inequality companies leads the authors to conclude that a group of less financially oriented institutional investors (perhaps driven by governance considerations or public / client attitudes) believe low inequality to be better and so drive up the share price of low inequality firms. However, these low inequality firms produce more negative earnings surprises and downgrades, resulting in them delivering lower shareholder returns from their over-priced starting point. In other words, a group of investors mistakenly views low pay inequality as a positive performance indicator, and these investors over-pay for such companies as a result.

It's not pay at the top that counts, it's pay at the bottom

All of these studies paint a very consistent picture. The most rigorous evidence on how pay inequality affects company performance seems to point in the same direction: on average, high inequality firms tend to perform better, consistent with the idea that hiring the best management talent and creating incentives for progression within the company lead to better performance. Of course not every high inequality firm will be better, and there will be cases of unjustified as well as justified inequality. But this very consistent evidence across three quite different major economies does indicate that the widely held view - that pay inequality is bad for your company's health - is inconveniently untrue.

However, increasingly evidence shows that pay at the bottom does matter. There's a strong literature on the concept of 'efficiency wages' - that paying more than the bare minimum enables you to hire better, or retain more motivated, employees. More broadly, Professor Alex Edmans of London Business School has shown how treating employees well, as measured through ranking in the Great Companies to Work For survey, leads to significantly stronger longer term performance.

It also appears that pay at the bottom is of greater concern to employees. One of my co-panelists at the High Pay Centre event was Alun Humphrey from NatCen research group. He presented data from the European Social Survey that shows that the UK is actually amongst the most relaxed European countries when it comes to high pay:

Approaching two-thirds of respondents in the UK felt that pay of the top 10% was fair or too low, the third most positive attitude to high pay amongst 19 European countries.
We were fifth out of 19 in terms of the proportion of people (around 60%) saying their own pay is fair or better.

By contrast, around 80% of us think that the pay of the bottom 10% of the employed population is too low.

Fairness matters

None of this means that companies don't need to consider the relationship between executive pay and wider employee pay. On the contrary, this is particularly crucial given current events and it would be tin-eared to do otherwise.

In research carried out by PwC in conjunction with Dr Sandy Pepper of the London School of Economics and Political Science we found that executives globally accepted that organisations were social entities that should apply principles of fairness in the same way as societies. One of the positive features of the new UK Corporate Governance Code is the emphasis it places on boards overseeing wider workforce practices including pay. This is leading to changed conversations and leading companies are being increasingly transparent in how they consider pay fairness. Barclays, Standard Chartered, and Unilever are examples of FTSE-100 companies that have produced, respectively, a Fair Pay Report, a Fair Pay Charter, and a Fair Compensation Framework to explain and open up to scrutiny their approach to wider employee pay and fairness. Indeed at the High Pay Centre event, participants acknowledged that it was the changes to the UK Corporate Governance Code that had been most effective at focussing attention on fairness, not the pay ratio disclosure, which companies viewed as a flawed statistic.

It is helpful that boards have been encouraged to think about these matters as considerations of fairness are coming to the fore in response to COVID-19. Companies need to consider what is fair in relation to CEO pay when shareholders are in many cases foregoing dividends, employees are being furloughed, and companies are being supported by Government debt guarantees. These are legitimate debates and companies cannot afford to be tin-eared.

But this shouldn't be the main focus. Of course excessive CEO pay should be challenged, and unjustified outliers brought back into line. Companies that show no regard for fair treatment between employees and executives will rightly suffer damage to their reputation. But companies would be better judged by the positive support they provide for employees during this time. Initiatives on wider workforce pay and employee wellbeing, grounded in solid principles of fairness and consideration for others are much more likely to yield results that are positive for companies and employees alike than knee-jerk reactions to public pressure or a mindless obsession with pay ratios.

It is on their treatment of the wider workforce that companies should be held to account.