Narrowing the Wage Gap: a Necessity for Successful Organizations

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Narrowing the Wage Gap: A Necessity for Successful Organizations

Abstract

In the United States, company executives commonly earn more in one day than some of their employees make in one whole year. This pay gap occurs more in the United States than in other industrialized countries, such as Japan. Renowned businesspeople, such as J.P. Morgan in the early 20th century and Peter Drucker in the 21st century, have asserted that CEOs should make no more than 20 times that of the lowest paid employee; however, this country commonly sees CEOs making more than 2000 times as much as their lowest paid employee. By examining scholarly data, this paper will argue that the pay gap is a problem that needs to be solved. This data clearly shows that such pay gaps cause problems with employee morale, productivity, and perception of the company. Although some may argue that CEOs take on a greater risk and therefore deserve this kind of pay, the astronomical gap between what many CEOs earn and what their lower-level employees earn is a signal that greed has taken over American business practice.

Introduction

Imagine if banking one year’s earnings meant you would be able to live comfortablyuntil your 95th birthday. Although a fantasy for many rank-and-file employees, this is a realistic possibility for their company’s leader, or Chief Executive Officer (CEO). Professors Luis R. Gomez-Mejia, David B. Balkin, and Robert L. Cardy (2007) reveal this truth in Managing Human Resources:

[E]ach of the Fortune 500 CEOs could live to age 95 among the top [two] percent of Americans if he or she saved just one year’s pay. At the higher end, some could have $1.2 million a year for life by saving one year’s pay. (p. 357)

These astonishing statistics lead some to question “how much is ‘too much’ pay?” and “what is ‘fair’?” (Wagner, 1999, p. 9).This paper will show that executive pay at many United States corporations is significantly higher than that of lower-level employees and that this practice is unfair; not only is it unfair, but it should be changed because this gap causes unfavorable outcomes for companies; the pay gap is a problem that is solvable, for example through restructuring the board; and solving this problem would benefit not only employees but also shareholders.

Background Information

Graef Crystal (2008), named “America’s Leading Expert on Executive Compensation” by Fortune Magazine, explains that pay ratios have been debated throughout the centuries (¶ 2). Plato informed Aristotle that no community member should “possess more than five times the wealth of any other person” (¶ 2). During the middle ages, theologians of Catholic faith discussed the “doctrine of just price,” which harangued wealth gaps (¶ 3). Near the beginning of the 20th century, renowned investment banker J.P. Morgan concluded that “the ratio should be 20 times” (Crystal, 2008, ¶ 4), and Peter Drucker, a leading authority on management, later agreed, asserting that a company’s leader, or CEO, should earn no more than “20 times the company’s lowest paid employee” (Nwabueze, Scott, Horak, Mohammed, & Chhotu, 2006, p. 392).

In reality, this ratio seems almost laughable when we consider the reality. In fact, according to the latest edition of the Economic Policy Institute’s The State of Working America 2008/2009, CEOs of major U.S. corporations made, on average, 275 times more than their hourly employees in 2007 (Mishel, Bernstein, & Shierholz, 2009, p. 220). Simply put, American CEOs made more in a single workday than their hourly employees made all year. Furthermore, this ratio is significantly higher than European and Japanese norms:“a multiple of between 15 and 20” (Wagner, 1999, p. 9). Dana R. Hermanson (2006), the Dinos Eminent Scholar Chair of Private Enterprise at Kennesaw State University, confirms these norms (with slight differences) in a more recent article, noting that the “ratio is 11 in Japan, 15 in France…and 22 in the [United Kingdom]” (p. 36).

Additionally, Lawrence Mishel, Jared Bernstein, and Heidi Shierholz (2009) explain that between the years 1989 and 2007, CEO pay for a typical U.S. CEO grew 167.3 percent while the compensation of an average U.S. worker rose by a mere ten percent during the same period (p. 220). Accordingly, the income gap between CEOs and lower level employees continues to escalate, which can result in unfavorable outcomes for organizations. Thus, organizations should aim to reduce the discrepancy in pay between CEOs and their rank-and-file employees by restructuring boards of directors and giving shareholders a greater voice in their company.

Unfavorable Outcomes for Organizations

As Uche Nwabueze, George Scott, Wayne Horak, Sarah Mohammed, & Joti Chhotu (2006), professors at HoustonBaptistUniversity, in the College of Business and Economics, point out, “compensation is a significant variable in determining employee job satisfaction,” and employees seek fair compensation systems (p. 389). Stephen P. Robbins, a professor at San DiegoStateUniversity, and Timothy A. Judge (2009), the Matherly-McKethan Eminent Scholar in Management at the University of Florida’s Warrington College of Business Administration, acknowledge that employees lose trust in their companies when they perceive compensation systems to be unfair; their job satisfaction declines considerably as well (p. 89). Additionally, when employee job satisfaction decreases, motivation and performance suffer as a result (p. 88).

Similarly, professors James B. Wade of Rutgers Business School, Charles A. O’Reilly, IIIof Stanford University’s Graduate School of Business, and Timothy G. Pollock of Pennsylvania State University’s Smeal College of Business (2006) note that the “huge size” of executive compensation packages, even if justifiable, can negatively impact others within the organization by provoking “feelings of inequity” that can reduce loyalty while amplifying “dysfunctional conflict” (p. 528). Moreover, these researchers discuss the effects of increased wage dispersion, citing lower productivity on individual levels as well as for the firm overall, diminished cooperation, “loss of group cohesion,” theft, reduced product quality, and “increased turnover” (p. 528). Nwabueze et al. (2006) also mention that the growing wage gap jeopardizes the credibility of an organization’s leadership (p. 391). These outcomes negatively affect an organization and tend to result in higher costs. In Organizational Behavior, Robbins and Judge (2009) write that increased turnover results in rising costs for recruitment, selection, and training (p. 29). They even offer examples to illustrate these costs:

[T]he cost for a typical information technology company in the United States to replace a programmer or systems analyst has been estimated at $34,100; and the cost for a retail store to replace a lost sales clerk has been calculated at $10,445. (p.29)

Additionally, increased turnover augments lower productivity as new employees have to be hired and trained to replace those that have left (pg. 29).

The Problem is Solvable

Undoubtedly, organizations should take action to reduce these unnecessary, added costs and reduce the discrepancy in pay between CEOs and lower level employees. Organizations should begin by restructuring their boards of directors as boards, with the assistance of a compensation committee, are responsible for establishing executive compensation packages (Gomez-Mejia et al., 2007, p. 360). Steven T. Petra, a certified public accountant (CPA) and associate professor at the Frank G. Zarb School of Business at HofstraUniversity, and Nina T. Dorata, a CPA and assistant professor at the Peter J. Tobin College of Business at St. John’s University (2008) recommend “separating the positions of Chairperson and CEO, relying on small boards, and limiting the number of other boards on which a board member may serve (p. 150).

They explain that a CEO’s influence over its company’s board of directors can vary, and evidence reveals that the compensation of CEOs “increases as their influence over the board increases” (Petra & Dorata, 2008, p. 143). This is especially true in organizations where CEOs fill the role as chairperson of the board because their responsibilities entail “running the board meetings, setting agendas and overseeing the processes of hiring, firing, and compensating top management” (p. 143). They cite the findings of accounting professors John E. Core and Robert W. Holthausen of the University of Pennsylvaniaand David F. Larcker ofStanfordUniversity’s Graduate School of Business, which are also confirmed by their own study: “CEO compensation is higher when the CEO is also the board chair” (p. 143). Additionally, CEO’s influence over its board of directors grows in accordance with increases in the size of the board as “large boards require more members to join together as a majority to challenge the CEO than small boards” (p. 143).

Shareholders Can Have a Greater Voice

In addition to restructuring the board, organizations should allow shareholders to have a greater voice in their company. In a roundtable discussion with moderator Ralph Walkling (2008), Robert Monks, cofounder of Institutional Shareholders Services and LENS(a shareholder activist investment firm), shares his thoughts: the “say on pay” proposal could be a possible solution to the issue of escalating executive compensation (p. 144). The “say on pay” proposal is defined as a “non-binding proposal submitted by a shareholder to be included in a company’s proxy materials that calls for an annual shareholder advisory vote on a company’s executive compensation policies and practices” (Krus & Morgan, 2008, p. 4).

This vote would allow the shareholders of the corporation to give a ‘thumbs up’ or ‘thumbs down’ vote annually in regards to its company’s executive compensation packages (p. 4). Monks explains that Britain has been utilizing this “say on pay” practice for nearly ten years, and it is deemed a success there. In fact, he cites the findings of a study conducted by professors Sudhakar Balachandran of Columbia University and Fabrizio Ferri and David Maber of the Harvard Business School: “U.K. votes on pay have resulted…in ‘markedly fewer rewards for failure’” (Walkling, 2008, p. 144).

The Other Side of the Debate

Some research (e.g. Dobbins, 2007) suggests that CEOs and other executives deserve higher pay because their “risk is inherently more substantial” (p. 455). But what about the risks made by lower-level employees, for example the risk that a Wal-Mart employee takes when he or she cannot afford good healthcare for his or her family? As we have seen, the United States is out of control when it comes to the ratio of executive pay to that of lower-level employees. And as mentioned earlier in this paper, employees become dissatisfied and they lose motivation when they perceive the pay system at their workplace to be unfair.

Conclusion

The wage gap between executives and lower level employees is widening in the U.S., with company leaders making more in one day than their employees make all year. Obviously, this is significantly more than Plato’s recommended ratio of “five times the wealth of any other person” in the community as well as J.P. Morgan’s and Peter Drucker’s assertion of “20 times the company’s lowest paid employee.” Although many can agree that executives deserve more than their rank-and-file employees, 275 times as much seems excessive, especially when compared to the norms in Japan and Europe. This widening income gap can undermine an organization’s leadership and trigger “feelings of inequity,” which can lead to unfavorable outcomes for the organization, including additional costs.

As noted by Roger Enrico of PepsiCo concerning his employees: ‘We can’t succeed without them – and if they are recognized and treated fairly our company is going to do better’ (in Wade, O’Reilly, & Pollock, 2006, p. 528). Thus, in order to be successful, organizations must reduce the discrepancy in pay between CEOs and lower level employees by restructuring their boards of directors and giving shareholders more say in their company.

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