June 22, 2018

Is Current Employee Compensation Sustainable?

In the modern world, the term ‘sustainable business practices’ most likely conjures images of proper resource management and greenhouse gas mitigation; however, the sustainability of a business is not limited to its impact on the environment.

At its core, sustainability refers to the ability to continue upon the same trajectory while simultaneously supporting long-term balance. The current state of employee compensation in the United States is unsustainable and companies not paying attention to this governance factor present a material risk to long term investors.

A recent study conducted by the Economic Policy Institute illustrates the expanding divergence by showing that CEOs went from making 20 times more than the average worker in 1965 to making 271 times the average worker in 2016.

And this growth in CEO compensation is in light of the fact that there is a growing mismatch between the pay of CEOs and the performance of CEOs.

The discrepancy between the performance and total package of CEOs is exemplified by the large compensation package of iHeartMedia’s CEO Robert Pittman. Pittman was paid $14 million in the 12 months leading up to the iHeartMedia bankruptcy. In fact, in the year that Pittman lead iHeartMedia to bankruptcy, his bonus alone was larger than his total compensation from when he became CEO in 2011.

Why then, when many boards claim to desire to link CEO compensation to business performance, does the problem persist?

The New York Federal Reserve found evidence that when CEOs are paid highly in stock or options, they become fixated on actions that will boost the company’s stock price in the short run. Such failure to invest in a corporation’s long-term future leads to detrimental effects in terms of lack of innovation and investments in projects beneficial in the long run. In fact, CEO compensation is often tied to performance metrics such as earnings per share, which can easily be inflated through corporate buybacks.

Such actions expend corporate cash for the purpose of boosting short-term performance metrics, rather than innovating and constructing a viable business.

This spring, a new mandate from Dodd-Frank went into effect requiring that companies release the following ratio: CEO Compensation/Median Employee Compensation

While CEO Compensation is not a new data point, the latter half of the equation -Median Employee Compensation- is a new disclosure and opens up a whole new can of worms for corporations. In particular, this disclosure shines light upon the gender gap when it comes to employee compensation.

It is a well-known statistic that women in the United States make 79 cents on the dollar in comparison to their male counterparts. As Median Employee Compensation becomes a widely disclosed statistic, female employees finally have transparency into where they stack up to their coworkers and, consequently, more leverage in salary negotiations.

This new disclosure presents a material portfolio risk to companies with unfair pay practices. Salesforce took the gender gap issue head on when they conducted a 2015 audit into their own pay practices. Despite a consistent ranking as one of the top places to work and a CEO with a strong liberal voice, Salesforce found a pay discrepancy amounting to $3 million across the company in 2015. After the acquisition of 13 companies in 2016, Salesforce ran another pay audit and found that the pay gap was back, resulting in an additional $3 million paid to eliminate the gender pay gap again.

With a new, alternative data point now widely available, investors are able to screen for companies that have disproportionate CEO Pay. A large discrepancy may present portfolio risk as CEO’s with highly incentivized pay packages are in danger of putting short-term financial goals ahead of sustainable business practices and long-term shareholder value. Additionally, as more female employees demand equal pay, the price of equalizing pay will have a material effect upon the income statement of corporations and subsequently shareholder value.

Sources:

“CEO Pay Continues to Rise as Typical Workers Are Paid Less.” Economic Policy Institute, www.epi.org/publication/ceo-pay-continues-to-rise/.

Fuhrmans, Vanessa. “CEO Pay and Performance Often Don’t Match Up.” The Wall Street Journal, Dow Jones & Company, 14 May 2018, www.wsj.com/articles/ceo-pay-and-performance-dont-match-up-1526299200.

Alsin, Arne. “What’s The Harm In Excessive CEO Pay? Answer: Long-Term Damage To Shareholders And Pension Funds.” Forbes, Forbes Magazine, 8 Sept. 2017, www.forbes.com/sites/aalsin/2017/09/07/whats-the-harm-in-excessive-ceo-pay-answer-long-term-damage-to-shareholders-and-pension-funds/#73044ad64aea.

Brickley, Peg. “Pay for IHeart CEO Rose as Bankruptcy Loomed.” The Wall Street Journal, Dow Jones & Company, 15 May 2018, www.wsj.com/articles/pay-for-iheart-ceo-ballooned-as-bankruptcy-loomed-1526417204?cx_testId=16&cx_testVariant=cx&cx_artPos=0&cx_tag=contextual&cx_navSource=newsReel#cxrecs_s.

“GE CEO Jeff Immelt’s Retirement Pay May Be A Lot More Than You Think.” Fortune, Fortune, fortune.com/2017/06/12/ge-ceo-jeff-immelt-net-worth/.

“Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts – Federal Reserve Bank of New York.” FEDERAL RESERVE BANK of NEW YORK, www.newyorkfed.org/research/staff_reports/sr531.html.

MacLellan, Lila. “Denial, Bargaining, Acceptance: Salesforce’s CEO on His Reckoning with Equal Pay for Women.” Quartz at Work, Quartz, 16 Apr. 2018, work.qz.com/1253580/salesforce-ceo-marc-benioff-tells-60-minutes-about-his-reckoning-with-the-gender-pay-gap/.