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The Bottom Line for Achieving Internal Pay Equity

by Christine S. Azar
Corporate Counsel |
Beginning in the 1980s, the gap between the compensation paid by many U.S. corporations to their top executives and the compensation of their "average" worker has grown exponentially

Beginning in the 1980s, the gap between the compensation paid by many U.S. corporations to their top executives and the compensation of their "average" worker has grown exponentially. The disparity from top to bottom in U.S. corporations is also vastly greater than in other countries, particularly in Europe and Asia. It is not uncommon for the CEO of a U.S. company to make hundreds of times that of the lowest-paid worker in the same company.

The rationale for this has been that the board must attract the "best and the brightest" to lead the company in order to maximize profitability. Logic holds, therefore, that they must pay the most to beat out the competition. To be clear, there is nothing wrong with hiring capable (even if high-priced) talent to lead the charge into an uncertain future. But it is time for companies and their boards-in particular their compensation committees-to reassess this logic and determine whether paying a CEO hundreds of times over what the average worker at the same company makes is a viable model over the long term.

Before a solution can be proposed, the problem must first be properly framed. Putting aside the question of whether the top talent is really lured so easily by money alone, to date there has been no demonstrated correlation-under any reliable metric-between executive pay and corporate performance. Ironically, what really happens is that you create a workforce with low morale and a high risk of reduced productivity, leading naturally to lower profitability-a direct contradiction to the rationale behind the bloated pay.

To date, shareholders have been largely unable to rectify the situation. "Say-on-pay" votes have been frequently ignored, and virtually every court hearing a shareholder challenge to an executive compensation package has found that compensation is a quintessential topic for a board's business judgment and has refused to strike down even the most egregious of pay packages. The answer may be for corporate boards themselves to recognize that the justification for the enormous pay packages of the last 20-plus years is not supported and to make the appropriate changes. No doubt, shareholder pressure to do so-formally and informally-will continue to mount.

So once a board recognizes that a change is needed, what can they do? Several major U.S. corporations have already recognized that some measure of "internal pay equity" makes sense, and have voluntarily implemented policies designed to bring executive compensation in line with the workforce as a whole. They should be applauded, and their programs can and should serve as models for others.

The Securities and Exchange Commission, implementing a provision of the Dodd-Frank reform law, is also working on a proposed rule that would, at a minimum, require companies to disclose the gap between chief executive pay and the median pay for employees. This would allow shareholders to make informed decisions in their say-on-pay votes and when voting for or against board members who have implemented the pay packages. Sadly, much of corporate America is fighting against such a rule, knowing that the figures they would be forced to release would be outrageous to most Americans. Such opposition cannot stand. The solutions do not require radical changes and can be easily implemented by boards with the assistance of independent compensation experts.

There are several ways a company can approach the problem and attempt to ensure some level of internal pay equity. One common tactic is to compare the chief executive's pay with that of the workforce as a whole. While this has the visceral appeal of making sure there is no one person getting rich off the backs of the shareholders, it does not really address the entire issue. The problem remains if there is a large group of C-level executives each making multi-million dollar pay packages.

The other more comprehensive solution is to compare all of the senior management team to the general workforce. This latter approach gives a board some flexibility to pay more for a particularly sought-after CEO if they truly believe that he or she would add value, not unlike a professional sports team operating under a salary cap. It also requires the board to think about appropriate compensation packages for more than just one individual.

The board should still conduct a cross check to ensure that the CEO's compensation is not out of line with the rest of the management team. This methodology would lead to better management teams with appropriate pay packages. It is, of course, extremely important that, in assessing pay packages, a board considers all elements of the package, including salary, bonuses, long-term incentives such as stock options, perquisites, and the like, and not just the cash component. Most boards or compensation committees would be wise to engage a compensation expert, at least initially, to assist in the analysis. Many companies already conduct such an analysis so the defense that "it's too hard" does not ring true to most investors.

Why should a board engage in this analysis and make reasonable attempts to implement some internal pay equity? One, it's the right thing to do. We are losing our middle class in this country and, as we all have seen in the recent Occupy movement, the perception-and perhaps the reality-is that it is the "one percent" versus the "99 percent." That is not healthy for any country or any economy.

If the philosophical arguments are not persuasive enough, another reason is that it's better in the long run for the corporation. Throwing money at a select few at the top without any definitive proof that it enhances bottom-line performance is a waste of corporate assets.

Finally, and quite pragmatically, if a board implements a program of internal pay equity, it can boast about it in its public filings, and the next say-on-pay vote is likely to go much more smoothly. Whatever the reason, it is imperative that corporate boards just get it done, and soon.