New study: Why CEO pay matters

Breakthrough research examines perceptions of fairness; how over- or underpayment cascades to lower organizational levels

HANOVER, MD, September 25, 2006--Executive compensation scholars have released new, breakthrough research analyzing perceptions of fairness in executive pay and how CEO over- or underpayment cascades down to lower organizational levels.

The paper, "Overpaid CEOs and Underpaid Managers: Fairness and Executive Compensation," looked at data from over 120 firms over a five-year period and is the most comprehensive study of its kind to be conducted. Authored by James B. Wade at Rutgers University, Charles A. O'Reilly, III at Stanford's Graduate School of Business, and Timothy G. Pollock at Pennsylvania State University's Smeal College of Business, it will be published in the September/October 2006 issue of Organization Science.

The techniques of Operations Research (O.R.), the discipline of applying advanced analytical methods to help make better decisions, drove the analysis that appears in the paper. Among the key findings:

  • CEO Overpayment Has Higher Costs Than Previously Realized: Arguments have been made that even if a CEO is overpaid, a large company can easily absorb the cost. However, the researchers found that CEO pay has direct consequences for compensation at lower employee levels. That's because the effects of CEO overpayment cascade – at diminishing degrees – down to subordinates. For example, based on their models, where one CEO was overpaid by 64 percent, individuals in his/her company at Level 2 (COO, CFO, etc.) were overpaid by 26 percent, while individuals at Level 5 (division general managers) were overpaid by 12 percent. The cumulative effect of this systemic overpayment impacts overall organizational performance and shareholder value.

    Professor Charles O'Reilly, a co-author at the Stanford Graduate School of Business, notes "Given the large sums paid to some senior executives, the total cost for overpayment could be a big number – and, in some cases, significantly affect shareholder returns."

  • CEO Pay Impacts Subordinate Turnover: The study found that CEOs serve as a key referent for employees in determining whether their own pay is fair. Simply put, if the CEO is overpaid, subordinates are more likely to leave. The "turnover effect" becomes more pronounced the farther away you get from the CEO level. It also appears that even if an employee is overpaid relative to the market, if their CEO is overpaid by a larger percentage than they are, they will have a greater propensity to leave.

    "CEO compensation impacts employee retention more than we realized," says lead author James B. Wade at Rutgers University. "Our research found that CEO overpayment is related to turnover, which can have important long-term consequences. It is quite possible that those most likely to leave because of perceived unfairness are precisely those employees coming up in the organization that would eventually rise to the top management team (TMT) level."

  • CEO Underpayment also Cascades: The study found that CEO underpayment tends to get cascaded through an organization, with multiplying effects. The researchers also found that if the CEO is underpaid more than you are, you are less likely to leave, but if the CEO is underpaid less than you are, you are more likely to leave. As Professor Wade puts it, "Underpaying a CEO could reduce turnover if subordinates are underpaid less than the CEO is underpaid."

  • Notions of Fairness are Powerful: On a positive note, the study found that CEOs tend to be concerned with the perception of fairness. If the CEO is paid generously, he/she will typically use their influence to pay others generously as well. And, if they are seen as being underpaid, that will also have an effect.

    "Our research shows evidence that CEOs are concerned with fairness, and that they are likelier to share rewards than they are to share burdens," says co-author Timothy Pollock of Penn State University. "But this can be expensive and has the potential to hurt a firm's bench strength if the rewards aren't fully shared."

  • Powerful CEOs Pay Employees More: Another interesting finding of the research is that more powerful CEOs (those who also serve as Chairman of the Board) tend to pay their employees more and that effect is more pronounced at higher levels, but diminishes at lowers levels. The effect disappeared at Level 5 (division general managers), but was strong at Levels 2 – 4 (the top management team through the junior vice president ranks).

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For more information or to arrange a briefing, please contact Doug Russell or Chuck Tanowitz at Schwartz Communications at (781) 684-0770 or by email at INFORMS@schwartz-pr.com.

About Organization Science and INFORMS
Organization Science is a publication of the Institute for Operations Research and the Management Sciences (INFORMS®). INFORMS is an international scientific society with 10,000 members, including Nobel Prize laureates, dedicated to applying scientific methods to help improve decision-making, management, and operations. Members of INFORMS work in business, government, and academia. They are represented in fields as diverse as airlines, health care, law enforcement, the military, financial engineering, and telecommunications. The INFORMS website is www.informs.org. More information about operations research is at www.scienceofbetter.org.


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