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Written by:   Dina Gerdeman, Harvard Business School “Working Knowledge”

It’s no surprise that business executives make more money than lower-level employees. But when that pay disparity between a CEO and the average worker is perceived as unfair, the result may be more than unhappy workers: A firm’s performance can deteriorate.

The gap between the large sums that CEOs take home versus average employee pay is taking on added importance in 2018, as public companies in the United States are mandated for the first time to disclose pay ratios between the CEO and employees. Harvard Business School Assistant Professor Ethan Rouen warns that if those disclosures are not made with proper context, they could ignite worker backlash and harm productivity.

“When you hear the amount that a CEO makes, it is going to seem outrageous. People are going to react with passion,” Rouen says. “So, it’s going to fall on every company that has to disclose these figures to provide some explanation and give a measured response justifying the pay disparity.”

Connections between wage disparity and company performance are detailed in Rouen’s recent working paper, Rethinking Measurement of Pay Disparity and its Relation to Firm Performance (pdf).

In essence, firms can flourish when they pay their workers fairly—and struggle when they don’t, the research suggests.

Resentment leads to employee backlash

Rouen’s research findings add a layer of understanding to previous studies on the effects of pay disparity on company performance, which produced mixed outcomes.

Some studies support an economic idea known as Tournament Theory, which says that as pay differences between job levels increase, the value of receiving a promotion also rises—spurring employees to put in more effort.

“People make work decisions based on what they’re being paid and what others around them are being paid,” Rouen says. “If the person above me is making a lot more money than I am, but I feel like I could work harder and get promoted to get the same salary, I will be motivated to do that.”

Other researchers backed the concept of Equity Theory, which says that pay disparity generates feelings of unfairness—leading lower-paid employees to shrug off their responsibilities or leave their jobs. In other words, Rouen explains, if employees feel their hard work isn’t being rewarded, “this pay disparity will create resentment.”

“PEOPLE MAKE WORK DECISIONS BASED ON WHAT THEY’RE BEING PAID AND WHAT OTHERS AROUND THEM ARE BEING PAID”

Rouen believes the results of these earlier studies fall short because they don’t take into account how CEO and employee compensation are determined. In essence, they ignore the reasons for the pay disparity, which can make a difference in how the gap is perceived by workers.

Rouen set out to explore the factors at play. He obtained data from the US Bureau of Labor Statistics for 931 firms in the S&P 1500 between 2006 and 2013, including total employee compensation and the composition of the workforce.

He found that CEOs in the study took home an average annual paycheck of $5.8 million while the average employee earned $42,000, and determined the ratio of CEO compensation to mean employee compensation. He also figured out what he calls the “economic pay ratio” you might expect to see based on economic factors influencing both CEO pay and employee pay (such as worker performance and labor market characteristics), as well as the “unexplained pay ratio”—the portion of pay disparity not driven by economic factors.

Rouen then studied how these measures of pay disparity affected future firm performance. He found that firms with an abnormally high unexplained pay ratio saw their performance drop by as much as half, compared to their industry competitors that had low levels of unexplained pay disparity.

In the most glaring cases—about a fifth of the companies studied—not only was the CEO overpaid, but the employees were underpaid, as well. “When both occur—the CEO is overpaid and the employee is underpaid—that’s when you really see the firm performance suffer,” Rouen says.

These firms can feel the backlash in a variety of ways: They may suffer weak corporate governance, lower sales, and higher employee turnover.

“You have this high turnover, and that is incredibly costly because you have to search for new people and train them, plus you have a short-term decline in productivity,” Rouen says. “And then you have the people who stay but are dissatisfied and won’t work as hard. If you’re not making your employees happy and creating an environment where they’re doing their best work, your firm is not going to succeed.”

The research found that as compensation at a firm moved closer to the expected levels based on economic factors, firm performance increased.

Pay ratios need explanation

Rouen was particularly motivated to study the issue because the US Securities and Exchange Commission in September 2017 adopted a rulestemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule mandates that companies disclose the ratio of the CEO’s compensation to median employee pay starting in the 2018 proxy season.

Sources: “How Much (More) Should CEOs Make? A Universal Desire for More Equal Pay” by Sorapop Kiatpongsan and Michael I. Norton, copyright 2014, Perspectives on Psychological Science “Executive Paywatch: High-paid CEOs and the Low-Wage Economy,” copyright 2015, AFL-CIO

Rouen is concerned those pay ratios may appear misleading to both employees and investors because, in some cases, economic factors that drive those earnings differences won’t be apparent. For instance, Apple is likely to have a CEO-to-employee pay ratio that is much higher than other firms in its industry. That’s because the company employs a large number of retail workers who earn less than, say, engineers, and that lower pay grade will skew the average employee pay figure lower.

“You may say the pay ratio at Apple looks outrageous because it might be 200 to one. This is a number people will latch onto, but at the same time, it’s not really fair, and it won’t capture what regulators are hoping to capture,” Rouen says.

Once the new SEC disclosure rule comes into play, firms should brace for some worker disgruntlement.

“WHEN YOU DISCLOSE COMPENSATION, YOU WIND UP LOSING TALENT”

“When you disclose compensation, you wind up losing talent,” Rouen says. “[Many companies] will see this negative reaction from employees, who know how much people at other companies are making, and that can change their expectations about what they should be making.”

Companies should offer detailed information to investors and employees outlining the economic justifications for their pay ratios, Rouen says. For example, firms can spell out whether a simple factor like geography is creating pay diversity; clearly, an employee in New York City will be paid significantly more than a worker in rural Alabama due to huge differences in the cost of living.

Corporate culture creates large impact

In addition to providing a clearer explanation of pay disparity effects, the study also spotlights the importance of corporate culture in creating value for employees.

“The evidence more and more suggests that corporate culture is a first-order driver of company performance,” Rouen says. “It’s something that can differentiate one company from another in a competitive industry.”

Companies can boost workplace culture in ways beyond compensation, particularly by providing promising career opportunities and allowing workers to pursue personal interests at work, Rouen says.

“Yes, people work for money, but they also work for other things. Firms should think creatively about how to retain their top talent,” he says. “Executives need to determine not just how to pay their employees better, but how to make their employees’ lives better in some way.”