The pay ratios between CEOs and average employees are once again in the news. This is partly because proxy season always raises this issue and partly because there is a move in some circles to do away with the new pay ratio disclose rule that is part of Dodd-Frank. This year’s ratios will likely be bigger than last. The same will likely be true for most years in the foreseeable future. Here’s why. The average annual increase for the average employee has been between 2.6% and 3.2% for several years. The use of equity compensation and other long-term compensation tools went down over at least the past decade. At the same time, executive base pay has increased between 5% and 8% most years over most of the past decade. During this period, the use of long-term incentives, including equity, has increased.
Take a look at this chart. The bottom line shows the change in pay ratio over 20 years if the average person received average annual increases of a very average 2.7% and a CEO received an average base pay increase of 5.5% over the same period. The top line shows the change if you include modest short-term incentives for both groups and a modest annual equity award for the CEO.
We start with a base pay ratio of 20X. When we add in incentive pay, it becomes 41.7X. Over a twenty-year period, the bottom line grows to 34X and the top to 71.5X. This is the power of simple compounding. This doesn’t account for the potential growth of stock prices or any other variables. But, let’s, for a moment, imagine such a simple world.
If we wish to bring the ratio at the end of our 20-year scenario back to the level it started, we need to have the average employee receive annual increases of 5.5% for twenty more years, while the CEO would need to accept annual increases of 2.7%. So, if we just convince our executives to have pay increases that are not only lower than their average employee but also less than that of their peers, we can “fix” this problem.
Let’s be realistic. That’s unlikely to occur.
Even if we start giving our average employee the same annual increase as the CEO, the pay ratio will simply remain constant. It is a simple fact that the best most average employees can hope for is a stagnation of pay ratios, not a correction in them.
But perhaps stagnation is a reasonable near-term goal. In my last post, I discussed doing nothing about pay. Paying the same amounts and methods as everyone else doesn’t make your pay package “competitive.” It puts you at a competitive disadvantage.
Maybe you should explore changing your compensation philosophy to give annual increases for your rank and file at the same rate as those for your executives. Even over a five-year period, you would set yourself apart from your peers. It would be difficult for them to bridge this gap once they realized it was occurring
If you took another step and simultaneously provided better management training and communications, you may forever separate yourself from the pack. Let’s discuss the arguments against this strategy in the comments section!
Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and considered a leading expert on equity compensation issues. Dan has written several industry resources including a recent Performance-Based Equity Compensation issue brief. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”,“Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation.