Corporate Governance

A Wage Imbalance Between the CEO and Workers Sends a Bad Message

Research explores the psychological effects of executive pay on corporate life.

April 01, 2007

| by Stanford GSB Staff

Huge salary imbalances between CEOs and the people who work for them can send bad vibes throughout an organization, weakening loyalty and eroding the talent pool, says Charles O’Reilly, director of Stanford GSB’s Center for Leadership Development and Research.

Every year the same ritual is played out in the business press: Compensation figures for the highest paid chief executives evoke predictable gasps about overpayment. Although economists have found that many CEOs are worth every nickel they get, social scientists are looking more closely at the psychological effects of executive pay on corporate life. Among them is O’Reilly, the Frank E. Buck Professor of Human Resources Management and Organizational Behavior, who has conducted a series of studies that try to explain CEO compensation, ranging from how corporate boards decide upon salaries to how social status figures in setting executive pay. One of O’Reilly’s latest papers, researched with James Wade of Rutgers University and Tim Pollock of Pennsylvania State University, examines how chief executive salaries affect employees. The study found that inequity in CEO pay triggers increased turnover among managers below the chief executive.

Using data from 120 large public companies over a five-year period, O’Reilly tracked five levels of senior managers from vice president to division general manager. He found,for example, that in one firm in which the CEO was overpaid by 50 percent compared to the industry norm and the general managers were underpaid by 50 percent, turnover among the general managers was 18 percent higher than at firms whose CEOs were equitably paid. The turnover of such seasoned managers, argues O’Reilly, has a corporate cost because it robs the firm of valuable internal experience that new employees will take years to develop.”People have been trying to justify why CEOs get paid so much,” says O’Reilly.”What people haven’t been looking at is the consequences of making a wrong decision — paying too much or too little. This study is evidence that there are consequences. Overpayment leads to an increased wage bill. That’s money the shareholders would otherwise get. Overpayment of the CEO also leads to turnover at lower levels.”

Although the study tracked only lower levels of senior management, it suggests that the negative consequences of CEO overpayment are likely to trickle down. “The same psychological processes can work in an automobile assembly plant,” says O’Reilly.”The CEO gets a huge bonus, but the company is not doing well and workers feel comparatively underpaid. What is the likely impact? Workers may decrease their effort. They may increase allegiance to the union.”

O’Reilly discovered that inequity itself also cascades down through senior management from the CEO. He found that if the CEO was overpaid, the executives under him tended to be overpaid, too — magnifying the cost to shareholders. For example, in a case where the CEO was overpaid by 64 percent compared to the norm (the maximum in O’Reilly’s sample),executives one step below were overpaid by 26 percent. However, the generosity wore off at lower management levels. Those at level five, such as division general managers, were overcompensated by only 12 percent.

Judgments about fairness permeate organizational life, says O’Reilly. Twenty-five years’ worth of research has created substantial evidence attesting to the powerful and pernicious effects inequity of all kinds can have on organizations. Studies by other researchers have shown that when a group of employees was temporarily assigned to lower status offices during an office relocation, they lowered their performance. Lower-status employees assigned to better offices increased their output. Related research has also shown that inordinate wage gaps are associated with lowered productivity, loss of group cohesion, lower quality, and even theft.

Wage gaps may also increase the tendency for individuals to perceive more inequity than actually exists, which can amplify the dysfunctional effects. More boards of directors should start looking at executive pay as a social, and not purely economic, corporate issue, says O’Reilly.

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