Shaming Your Highly Paid CEO

SMITH BRAIN TRUST — Can American companies be embarrassed out of paying their CEOs hundreds of times what the average worker makes? The SEC wants to find out. By a 3-2 vote, the agency recently ordered that companies begin disclosing the ratio of their CEO’s pay to that of the median employee.

A widening gap: The rule’s backers believe it's indefensible that CEO pay has grown in the last-half century from 50 times what the average worker makes to roughly 300 times, even as middle-class wages have stagnated. On the other hand, a Republican commissioner disparaged the rule as a "useless" and expensive regulatory burden.

Not just about equity: Management professor Hui Liao at the University of Maryland's Robert H. Smith School of Business, who has studied the economics and psychology of pay structures, thinks the regulation makes sense on two fronts: "There is both a business case that can be made for more pay transparency and a fairness-related consideration," Liao says. Yet there remains plenty of room for debate. Michael Faulkender, a professor of finance at the Smith School, argues that the regulation "was imposed upon the SEC by partisans in the Congress for entirely political reasons."

Multiple pay gaps: While pay gaps between CEOs and average workers draw the most attention, Liao's research shows that entry-level employees care more about the lower gaps between them and middle managers. Middle managers, in turn, care more about the upper gaps between them and senior leaders. As long as the vertical gaps are perceived as merit-based, they can drive high achievement.

Have it your way: For pay gaps to work as a motivator, however, transparency is needed. Workers can't aspire to the next pay range if they don't know what it is. Transparency also lets workers self-select into structures that suit them best. People whose aspiration is mid-level management may choose one type of structure, while MBAs gunning for elite positions may choose another. (And those who prefer equity above all else may choose yet another.) Liao says the SEC rule might enable "better matches between employees and their preferred structure."

Sunlight's virtues: Transparency also promotes equity because it exposes the lateral pay gaps that are difficult to justify, Liao says. Think of what happens when two people doing the same job discover that one is making much more than the other. Citing the merits of transparency, President Obama issued an executive order last year that forbade federal contractors from punishing workers for discussing pay — another move that Liao applauds. 

An "irrelevant" number: Faulkender, however, counters that there is already "vast disclosure" about CEO pay. The new command to divide CEO pay by the compensation of the median worker — who might be someone who works part-time, or overseas, or both — produces, in his view, "an irrelevant statistic for understanding whether CEOs are appropriately paid for their contribution and performance."

Who adds value? Where fairness is concerned, he argues, "the relevant determinant is the economic value-add of the CEO relative to the economic value-add of the median worker. If both are getting the same percentage of their economic value-add, there is no fairness issue." The new statistic is unrelated to that empirical question, he says.

A political PR tool: What's more, transparency can have unintended consequences. Mandatory CEO pay disclosure dates to the 1990s, and it appears to have incited an arms race in executive compensation. Faulkender doesn't think the new rule will have similar bad side effects, but it strikes him as pointless at best. "It will be ignored by the markets, costly for firms to generate, and only used as a public relations weapon by those on the left with an agenda," he says.