The Ideal CEO-to-Employee Pay Ratio? Much Lower Than You Think
Recently, a CEO told us something along the lines of this: "I am trying to set a bit of a frame for a remuneration conversation—for myself and other leaders. One way of talking about it is the ‘appropriate´ ratio of lowest to highest paid, from the front lines to CEO. I also recall you saying that if you ask employees what they think, the usual response is in the order of 6 to 8 times. Is my memory accurate? Are you aware of any empirical basis for this? Or have I made it up?!"
Before revealing if our client's memory is accurate or not, let's first stress the importance of this touchy subject.
Overpaid CEOs and underpaid employees
The phenomenon of firms with overpaid CEOs and underpaid employees is not new. In 1977, the late Peter F. Drucker, arguably the most famous management thinker, suggested the pay ratio between CEOs and employees be a maximum of 25-to-1.
However, in 2011, he scaled it slightly back to a ratio of 20-to-1. Drucker said at the time: "I have often advised managers that a 20-to-1 salary ratio is a limit beyond which they cannot go if they don’t want resentment and falling morale to hit their companies."
Sadly, his advice was not followed by many. In fact, the exact opposite happened, and to a massive and practically grotesque extent: The statistics on the pay gap ratio between CEO-to-employee indicate that it has increased from 20-to-1 in 1996 to 202-to-1 in 2018.
Take that in for a moment. Do some math if you’d like.
Instead of following Drucker's advice towards a fairer work environment, we have entered a period where executive pay has been rising almost exponentially, with executive fat cats now earning in days what front-line employees earn in a whole year.
The actual and estimated pay ratios
So, back to the client's memory. It was accurate. There is an empirical basis for his claim, and it can be seen in research being done by Kiatpongsan & Norton from the Harvard Business School.
In 2014, the duo published an article titled 'How Much (More) Should CEOs Make? A Universal Desire for More Equal Pay' in an academic journal called the Perspectives on Psychological Science.
In the article, the researchers reported data from 40 countries showing where the actual CEO-to-employee pay gap is insanely large and how people drastically underestimate the actual pay inequality.
For example, they showed that in the United States (where underestimation was particularly pronounced), the actual pay ratio of CEOs to front-line employees was about 354-to-1.
That means if an average front-line employee salary is something like $50,000 a year, the CEO is earning $17.7 million that year. If the salary breakdown is examined, the CEO makes the front-line worker’s pay in just one day
One freaking day.
However, when people were asked to guess the pay ratio between CEOs and front-line staff, they estimated only 30-to-1. That is lower by a factor of more than 10!
Ideal pay ratio
Estimated pay ratios were not the only thing the researchers asked their respondents about—they also asked them to share what they thought the ideal pay ratio for CEOs and their employees should be.
The results are telling. Where the estimated pay ratio across all respondents was reported to be 10-to1, the same group of people reported an ideal pay ratio of 4.6-to-1.
And there you have it. The ideal CEO-to-employee pay ratio is not even 5-to-1. That is nearly 50 times lower than the actual practiced pay ratio of 202-to-1.
So, most people not only widely underestimate actual pay gaps, they also work in environments where their desired pay ratios are a galaxy away from what they face in reality.
That seems like a bad formula that could lead to a lot of bad things.
Luckily, there are some exceptions to the rule out there. In fact, our own anecdotal evidence collected during our Bucket List visits even showed that some progressive firms go even more extreme in their equality.
For example, at the Basque ner Group, there is a rule is that the highest-earning 10% can earn no more than 2.3 times the salary of the lowest-earning 10%.
This might sound extreme, but these outliers believe that lower pay gaps are not only fairer for all people involved, they also believe that lower pay gaps are better for the success of their business.
Good for employees. Good for customers.
The belief of these outliers makes total sense. They know that fairness can play a critical role in shaping staff behavior. Besides, Drucker had already said that higher pay gaps would negatively affect staff morale and hurt the overall performance of their business.
However, the level of the pay gap does not only influence the staff of the business. It also influences how customers perceive that same business, as reported by researchers Mohan, Norton & Despandé.
In their 2015 paper titled, 'Paying Up for Fair Pay: Consumers Prefer Firms with Lower CEO-to-Worker Pay Ratios,' they showed that the disclosure of a company’s high pay ratio (e.g., 1000-to-1) reduces purchase intention relative to firms with lower ratios (e.g., 5-to-1). The researchers also showed that lower pay gaps actually increase ratings from customers of that business.
Two for the price of one
"It should be clear now,” we told the CEO. "Establishing fairer pay gaps means hitting two targets with one shot. Yes, it will boost your staff's morale; that’s for certain. But voluntarily disclosing this information to the world will also give your business a way to gain favorable perceptions from consumers."
And that's all we have to say. For now.
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