School of Business Administration

Innovative study yields unexpected results about CEO pay ratios

icon of a calendarOctober 17, 2019

icon of a pencilBy Susan Thwing

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Innovative study yields unexpected results about CEO pay ratios

Sha Zhao standing in front of a projector screen, smiling at the camera
Sha Zhao, assistant professor of accounting, explores the relationship between CEO pay ratios and employees. Photo by Phil Carter.

Sha Zhao, Ph.D., doesn’t believe in assuming. When looking at the intense policy debate over income inequality in the U.S., Dr. Zhao, an Oakland University Assistant Professor of Accounting, did not make the standard assumption that CEO pay was skyrocketing — as the gap between leadership and worker salaries widened — with little benefit to the company.

Instead, a recent study conducted by Zhao, along with Professors Qiang Cheng of Singapore Management University and Tharindra Ranasinghe of the University of Maryland, concluded that higher CEO-to-employee pay ratios can mean a more successful business.

The paper, Do High CEO Pay Ratios Destroy Firm Value?, was presented at the American Accounting Association conference in 2017 and received extensive media attention including from MSN Money and MarketWatch.

“A group of us were discussing the mandate by the Dodd-Frank Wall Street Reform and Consumer Protection Act, that requires a public company to disclose the ratio of its CEO’s compensation to the median compensation of its employees,” Zhao says.

Zhao says the increasing CEO pay ratio is a key catalyst of controversial policy debate over income inequality in the U.S.

“The Dodd-Frank rule provides transparency to shareholders about pay disparity between senior executives and workers, but there are other questions to ask as well. Do the high pay ratios depress employee morale? If so, is the demoralizing effect sufficiently large to harm the overall firm value and performance?” she says.

In the study, Zhao and her co-authors used information on worker salaries to examine how the ratio of CEO compensation to that of average workers relates to firm value and performance. The professors examined CEO pay ratios for 817 firms, whose CEOs had an average annual compensation of $7.8 million, and whose workers’ mean pay was about $74,000. They then measured the firm’s profitability and the market value of company stock and debt to its book value.

What they found, oddly enough, was that the higher the gap is between CEO pay and that of the median worker, the better the company performance.

“Taken together, these findings indicate that reductions in worker productivity (if any) due to high disparity between CEO pay and average worker pay are not significant enough to have firm-wide value and performance implications. They are also inconsistent with the notion that high CEO pay ratios signal governance failures and CEO rent extraction. In contrast, our results are consistent with the argument that firms with high CEO pay ratios are likely to be managed by more capable CEOs,” the paper says.

Importantly, the professors do not contend that the higher pay ratios cause the better performance, but the higher pay may reflect the search for better-performing CEOs who do lift company performance.

“The results are consistent with the argument that high CEO pay ratios are an outcome of market competition for scarce CEO talent,” Zhao says.

Using the results in many of her classroom discussions, Zhao says that opinions vary widely among her students, including conversations about what is fair pay, the balance of pay ratios and what it means to public perception. Zhao notes that the study focuses on economic aspects of pay disparity and does not allude to broader social norms such as fairness and social equity. Zhao hopes the findings will lead to further research, and in-depth discussion about these unresolved issues.

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