Why Big CEO-to-Employee Pay Gaps Aren’t All Bad

SMITH BRAIN TRUST – Maybe those wildly high CEO salaries aren't an entirely bad thing.

For years, critics have charged that the vast and widening gap between the pay packages for chief executives and a company's average employee (commonly referred to as the CEO pay ratio) is a moral failing on society. Others have claimed that it reflects a weak corporate governance structure, blaming boards of directors for heaping needlessly large compensation packets into the laps of top executives, at the expense of company productivity and profitability.

New research from Tharindra Ranasinghe, advanced assistant professor of accounting and information assurance at the University of Maryland's Robert H. Smith School of Business, sets aside the moral questions, and finds that from an investment and profits standpoint, generous CEO compensation packages in comparison to those of average workers can be a good thing.

"We find that high pay ratios for CEOs are associated with better corporate outcomes," he says, "both in terms of accounting performance and stock performance."

When it came to profitability, a company whose CEO-to-worker ratio was near the 85th percentile was found to have a return on assets that was 13 percent higher than companies at the median.

The research also knocks down the assumption that companies with lavishly compensated CEOs in comparison to the average worker must have weak corporate governance structures, finding they more often have stronger ones.

For example, companies with higher CEO pay ratios are more likely to make acquisitions that added value to the firm. And they were more likely to oust CEOs who deliver lackluster results.

Ranasinghe and co-authors Qiang Cheng of Singapore Management University and Sha Zhao of Oakland University analyzed 817 companies, whose CEOs had mean total annual compensation of about $7.8 million and whose workers' mean pay was about $74,000.

"We are not claiming that high pay ratios lead to better outcomes," Ranasinghe cautions. In other words, no amount of pay raises for a CEO would be guaranteed to improve a firm's performance.

According to the trade union federation AFL-CIO, in 2016, CEO of the S&P 500 earned an average 347 times what the average worker earned, putting them on pace to earn more in just two days of work than the average employee earns all year.

A half-century ago, an average CEO made just 20 times the pay of the average rank-and-file employee. By 2000, the ratio was about 100-to-1.

Ranasinghe says the CEO-to-worker pay gap has been widening because of scarcity of chief executive talent and "scalability." Companies have grown over the years, both in size and complexity, intensifying an already-scarce demand for highly talented leaders who can think through the vast, company-wide implications of the decisions they make.

"That talent is really critical," he says. "People at the higher level of the organization can make a bigger impact, so their talent would be valued more."

Outrage over the rates at which CEOs are compensated, relative to other workers, was particularly pronounced during the Great Recession, as companies laid off employees, while keeping their highly paid chief executives in corner offices, even rewarding them with generous salary increases.

Approved in 2010, the Dodd-Frank Act even included a provision that would require companies to disclose its total CEO's annual compensation, compared to the median pay of its workers. Supporters said the provision, whose implementation has been postponed, would shame companies into adopting less lavish, more prudent CEO compensation practices.

"When the public becomes concerned about large CEO-to-average-worker pay gaps, I think a large part of that concern has to do with fairness," Ranasinghe says. "When I talk to my nonacademic friends about this paper and I tell them, for example, that high CEO-pay-ratio firms perform better, they tell me, 'It doesn't matter; it's just not fair.' The public outcry is largely about this fairness issue."

He adds, "Our paper does not look at that angle. We are examining this issue from an economic efficiency perspective only. One good reason not to look at the fairness angle is that it's very difficult to define what you mean by 'fair.'"

Ranasinghe and his co-authors are scheduled to present their findings at the annual meeting of the American Accounting Association next month.

Read more: Do High CEO Pay Ratios Destroy Firm Value?