CEO Pay: When Highly Paid Is Not Overpaid

When people talk about CEOs being overpaid, they largely refer to extreme numbers from the United States thereby overlooking the fact that most countries in the world have very reasonable ratios of salaries for floor employees compared to their CEO. But even though these ratios are higher in some cases, still very appropriate reasons can be found to justify these discrepancies.

CEO compensation ratio

Agency Theory

One possible explanation for the national differences in compensation stems from the agency theory. CEOs tend to be risk-averse because they are strongly attached to the outcome of their actions in terms of salary, reputation and personal ties. In order to increase the top executives’ willingness to take risks, alternative pay strategies – including stock options or normal stock – have been increasingly explored. By attaching firm performance to compensation, shareholders are able to pay CEOs in accordance with the value they bring to the company. In the US, this tendency is considerably stronger, which partly explains why CEO compensation levels are higher and more volatile when compared to the rest of the world. In the US, only about 20% of the CEO’s pay is fixed salary, while the other 80% is awarded through perks, incentives and performance-related bonuses. The relative success of US corporations and the positive relationship between pay and performance justifies the high compensation for US CEOs.

Equity Theory

More generally, the current ratio in compensation levels can also be discussed from an equity theory point of view. In the context of organizational (distributive) justice, equity theory is conceptualized as fairness associated with outputs compared to the inputs. Salaries can be seen as the outputs here whereas the input can be seen as the magnitude of the responsibility and tasks an organizational member has. It may be obvious that a floor employee performing a single task in a factory over and over demands less sense of responsibility and prior knowlegde and experience than the task of a CEO who has to make daily decisions which influence thousands of people (if not more), varying from internal stakeholders like employees and shareholders to external stakeholders like customers, suppliers or even society at large! Mistakes made by CEOs therefore have way larger consequences for the firm and could potentially cost millions of euros. Based on these huge differences in responsibilities, it only seems logical that CEOs are getting paid significantly more than their collegues on the workfloor.

Capitalism

Providing further support to the legitimacy of top executives’ pay is our society’s economic system. Capitalism is widely regarded as the most productive and efficient system; thus, the unrestrained and free market economy should allow the owners of private entities to compensate managers as they please. Assuming efficient mechanisms of corporate governance are in place, the price of the CEOs (total pay) is determined by the supply and demand in the CEO market. CEOs should be able to earn at least as much as they could in his or her next best employment opportunity. By restraining CEO pay to certain levels, potential talented CEOs are likely to be driven away to positions yielding higher returns.

In this discussion, just like in any other, it is important to be on the lookout for arguments based on logical fallacies. To claim that CEOs are overpaid based on a couple of examples of one single country is like saying that Americans are smart because Stephen Hawking and Thomas Edison were American. It sounds appealing, but it incurs in a fallacy called hasty generalization.

Further reading: 

  • Adams, J.S. (1965). Inequity in social exchange: Advances in experimental social psychology, New York: Academic Press.
  • Martin, G., Washburn, N., Makri, M., & Gomez-Mejía, L. (2015). Not all risk-taking is born equal: The behavioral agency model and CEO’s perception of firm efficacy. Human Resource Management.
  • Sanders, G., & Hambrick, D. (2007). Swinging for the fences: The effects of CEO stock options on company risk taking and performance. Academy of Management Journal.
  • Sridharan, U. V. (1996). CEO influence and executive compensation. Financial Review.
  • Wilhelm, P. G. (1993). Application of distributive justice theory to the CEO pay problem: Recommendations for reform. Journal of Business Ethics.