Monday, May 01, 2006

The Myth of the Average Worker Pay Ratio

Fred Whittlesey
Compensation Venture Group, Inc.

Are CEOs overpaid? Many people think so. If so, many potential causes have been identified: CEOs with too much power, inattentive boards of directors, conflicts of interest by compensation consultants, the use of stock options – the list goes on. Depending on the source, the average CEO in 2005 was paid $10 million to $15 million dollars. This calculation usually includes base salary, annual bonus, payouts from multi-year bonus plans, cash-outs of stock options that were granted as much as ten years ago, and new grants of unvested stock and stock options that have only theoretical value today.

Are rank-and-file workers underpaid? Everyone, I suppose, feels a little underpaid. Depending on the source, the average American worker was paid about $40,000 in 2005. This figure includes base salary or wage and typically excludes overtime, tips, bonuses, and gains from stock-based compensation. The potential causes of this are deemed related to CEO pay – greedy executives, putting profit over people, etc.

Are CEOs overpaid compared to rank-and-file workers? If you read the media stories this year, and in previous years, you might conclude that they are. Many interest groups have determined that the ratio of CEO pay to the “average worker” is an appropriate measure of this problem. Some websites allow you to calculate exactly how underpaid you are compared to your CEO. According to these sources, CEOs are paid between 250 and 500 times that of the average worker, whoever that is.

Before we assess how much pay an executive receives relative to other workers, however, we need to ensure we have measured the pay level of each properly. Then we need to decide whether that is a relevant comparison.

Measuring executive pay

Who are these average CEOs that are purportedly paid hundreds of times more than the average worker? In most analyses, they are CEOs managing the largest public companies in America – usually the top 250, 350, or 500. These are the largest of the 10,000 or so public companies - the largest 3% to 5% of corporations in the country. Given that most managerial jobs pay more for managing larger operations and all other things being equal, we might expect these individuals to be among the top 3% to 5% in pay and we should not expect that they are paid at the average rate for CEOs managing any of the other 10,000 companies, some of which are only a few million dollars in revenue per year.

These large companies, being publicly-traded, all exist for the purpose of generating profit and value for shareholders. There are no private companies, government agencies, or non-profit organizations in the sample. Public companies generally pay their managers more than organizations in these other sectors and have types of pay available, such as stock options, that the others do not.

While this data indicates we might expect these CEOs to be among the highest paid people in the country it’s more difficult to arrive at a factor regarding the relative value of the individuals in the job. Most CEOs I’ve dealt with are highly intelligent, have advanced degrees - often from one of the top universities in the country, or the world - and have worked 70 or more hours per week for most of their career. Even if they weren’t CEO of a public company, people with a resume like that get paid much more than the average person.

The biggest issue in this, however, is the double-counting that goes on. I’ve never understood how one can justify adding together the gain on a stock option granted in 1996 and the theoretical value of an option just granted in 2005, plus the value of theoretical value unvested restricted stock granted in 2005, and include those in “pay” for 2005. There are related issues such as the notion that the “value” of a stock option (and thus the amount included in the pay calculation) is the amount the individual will have to pay the company to exercise that option someday, once it is vested. This is absolutely misleading and absurd. Yet leading business periodicals use the data from well-known data sources to report executive pay this way year after year.

Measuring worker pay

If we want to understand the pay level of the average worker in America, we would have to ensure this included a representative sample of workers of all kinds from companies in all industries, all education and experience levels, and so forth. We would have to ensure we included all forms of their pay – wage or salary, shift differential, overtime pay, bonuses, tips, commission, and stock-based compensation. Without digressing into which sources do and do not do this (hint: none do) it would in theory provide a good portrayal of how much the average worker is paid for his work. We would assume that these are average performers with average levels of education, and so forth.

And, we would want to be confident, too, that, those numbers represent pay for just one year, as no sensible analyst would add together pay numbers from the past 10 years with those from last year and call that “pay” for last year, would they?

Comparing workers

I can’t recall seeing a comparison of how much software engineers are paid versus postal workers, or how much superior court judges are paid versus bank tellers. I think this might mean that no one believes these would be relevant comparisons because different jobs with different educational requirements and different levels of responsibility should be paid differently. We don’t always know or agree how differently, but differently.

Because we’re comparing the average American worker’s pay to CEO pay, we would have to ensure that we’re including all non-CEO positions in that data – software engineers, postal workers, superior court judges, and bank tellers because they are part of the American workforce. We also would include CFOs and Executive VPs and Managing Directors as well as entry-level counter staff at fast-food restaurants. I think we all agree it wouldn’t be fair to exclude other non-CEO executives from that calculation, correct?

Now that we have constructed a fully representative sample of American workers, we’ll have to limit it to those that work for the 250 or 350 or 500 largest American public corporations just for it to be a fair comparison. We should probably only compare to the top 5% performers among all the non-CEO workers, particularly since this is America and we believe in pay for performance so if we’re looking at a group of top CEOs we should compare that to a group of top non-CEO employees. We then we could calculate a more accurate ratio between CEOs and all other workers.

And it would still be completely meaningless. If that’s how you like to spend your time to push your particular political agenda, however, I now feel that I’ve done everything I can to ensure an apples-to-apples comparison.

Having said that…

I am in no way trying to serve as an apologist for high executive pay levels. After more than 20 years in the field of executive compensation I have seen numerous examples of inappropriate pay for executives – not only in amount, but in reason and in form. Billions of dollars have been paid to thousands of executives who have ruined companies and workers’ lives. I have seen executives join a company shortly before a takeover and get millions in “change in control” payments. (Those payments, too, often appear in the executive pay calculations but not in average worker calculations and tend to inflate the ratio a bit.)

I also have seen numerous examples of inappropriate pay for nonexecutives – sales representatives that made far too much pay due to a flawed incentive plan; a receptionist earning more than double the market rate because she had been with the company for decades and there was no pay cap for any position; software engineers that joined a company at just the right time and cashed out their stock options just before the stock price crashed and the company went out of business due to a poorly developed software product. I have a friend who has a knack for joining companies shortly before they do major restructurings and layoffs; she’s made hundreds of thousands of dollars in retention bonuses and severance pay yet always found her next job right away…or contracted back to the company that just laid her off at double her previous pay rate, on top of the severance pay. (If that kind of data was captured in the “average worker pay” calculation, which it is not and never will be, the ratio might look a little different.)

If there is an excessive CEO pay problem, we won’t fix the problem by measuring the wrong things and then misinterpreting already flawed calculations. That only will encourage misguided legislation and we’ve had plenty of that. It also might encourage big shareholders and their advisors to begin bullying companies into change using arbitrary standards, and we’ve had plenty of that. Disclosure and publicity of pay allows us to identify the egregious situations and apply pressure to fix them but only when the data seem accurate to reasonable people.

I just read that U2 made $236 million on their 2005 tour - $3 million per show (about $1 million per hour) - which was far above Motley Crue’s $33 million for a similar number of shows (a paltry $400,000 per show, well under $200,000 per hour). I don’t think most Americans want to impose an arbitrary cap on CEO pay any more than we want to impose a cap on U2’s concert tour receipts because we know U2 would stop touring, and good CEOs would stop CEO-ing, and neither of those are to our benefit.

So let’s start focusing on the real problem and not on concocted metrics rooted in socio-political sentiments. There is a lot of fixing needed in executive pay practices and these average worker pay ratios have the potential to send us in the wrong direction.

1 comment:

broc said...

I believe the advocates for internal pay equity believe that some sort of alternative benchmark is necessary to counter the ills of peer benchmarking. Peer benchmarking too often is the primary factor considered when setting a CEO's pay level and has caused many of the excesses that we currently are stuck with.

So although internal pay equity may have limitations, it is simple to use and relevant because it deals with compensation design for the entire organization rather than the design of the CEO's pay package in isolation.

Comparison to rock stars doesn't work because true market forces are in play there (not to mention those situations are more akin to a founder of a company; innovators should be entitled to the windfalls they create). Journalists often fall into the same trap, as I note in my "Open Letter to All Journalists" posted on CompensationStandards.com.

Internal pay equity is widely misunderstood and it means different things to different people. But I believe that it is important to introduce alternatives to the ways that CEO pay levels are arrived at today because the process clearly is broken. Internal pay equity was good enough for J. Pierpont Morgan as a guideline for lending to emerging American businesses a century ago - it should be good enough for American businesses to use as one of their many tools in setting CEO pay levels today,

Broc Romanek
Editor, CompensationStandards.com