The Pay Gap That Matters Most

By HUI LIAO

SMITH BRAIN TRUST -- Conversations about soaring executive salaries often get emotional, especially in organizations that pay minimum wage to front-line workers. Money represents achievement and status, and finding out that CEOs earn 331 times more than average workers can spark indignation. Yet, if the goal is to motivate performance, new research from the University of Maryland’s Robert H. Smith School of Business shows that rank-and-file employees care more about the pay divide between them and middle managers. The study, which I co-authored with Wei Chi, Lei Wang and Qing Ye from Tsinghua University in China and Rui Zhao from the University at Albany-State University of New York, also shows benefits when companies remove some of the secrecy surrounding their pay structures.

Setting emotion aside, we explore compensation design as a strategic tool using tournament theory. Sports tournaments such as the Wimbledon Championships in London provide helpful analogies, especially when one considers that the winner earns about the same as a CEO in comparison to entry-level tennis professionals in the qualifying rounds. Organizations focused on attracting and motivating high achievers should consider at least three elements of tournament theory when allocating pay.

Think vertical

First, organizations must distinguish between vertical and lateral pay gaps in their hierarchies. Lateral gaps exist when workers at the same level of an organization earn different wages. Gender and minority studies often focus on these inequalities, which can demoralize team members. Consider the backlash Wimbledon would face if it tried paying different amounts to players at the same level of the tournament. This is partly why Wimbledon, under pressure, equalized its prize money for men and women in 2007.

Vertical pay gaps have a different effect. People expect to earn more when they climb a rung on the corporate ladder, just like tennis professionals expect to earn more when they advance in a tournament. If the pay stayed the same, then players would lose their incentive to dive for volleys and chase down lobs. Low performers might welcome equal pay, but high achievers prefer vertical gaps.

Add transparency

Many organizations shroud their pay schemes in secrecy. Some even punish employees who share their salary information. Companies with lateral pay problems might have something embarrassing to hide, which is one reason the White House signed an executive order on April 8, 2014, banning federal contractors from retaliating against employees who talk about their compensation. But vertical pay, a legitimate human resources tool, needs some sunlight to work as a motivator. After all, people can’t respond to an incentive unless they know about it.

Wimbledon players know exactly how much money is on the line when they reach match point. Organizers announce precise prize amounts at each level of the tournament before it starts. The same degree of transparency might not work in a corporate setting, but awareness of pay ranges associated with each step in the hierarchy can motivate effort.

Transparency especially benefits companies that pay for performance. Workers confident in their ability to deliver results — like top-ranked tennis players at Wimbledon — will gravitate to tournament settings with winners and losers. Risk-averse people looking for guaranteed raises based merely on showing up will shy away from such environments.

Spread the wealth

With so much attention placed on executive compensation — and who tops the latest list of CEO millionaires — many human resources managers overlook the performance implications of vertical pay gaps throughout the organization. Five-time champion Serena Williams might care about the grand prize amount at Wimbledon, but tournament newcomers might be happy to advance one or two rounds. Likewise, frontline workers might not see themselves in the C suite, but they will push themselves to lead a team or manage a project when they see rewards within reach.

We measured this phenomenon in a series of four studies, which looked at the upper pay gap between top executives and middle managers, and the lower gap between middle managers and frontline workers. Despite the obsession with CEO salaries at the top, we found that the lower gap has greater impact on motivating performance.

This means employers must think strategically about how they allocate money across all levels of an organization. Compensation design matters, and not just at the top.

Hui Liao, PhD, is the Smith Dean’s Professor in Leadership and Management at the University of Maryland’s Robert H. Smith School of Business. She presented her working paper, “Incentives to Move Up the Echelon: Impact of Inter-hierarchical Pay Gaps on Employee Performance,” at the 2014 Academy of Management annual meeting in Philadelphia, PA.

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