CEO pay-to-employee pay ratio tells us nothing about the competence of the CEO

Earlier this month, the Canadian Centre for Policy Alternatives (CCPA) published its annual report on the pay packages of chief executive officers (CEOs) at top public Canadian firms. The idea is to catch the headlines by stating on what day of the year these CEOs will surpass the annual income of the average Canadian worker. Generally, it happens in the first few days of January. This year, it was on January 2, meaning these CEOs earned 197 times what the average Canadian worker earns. This practice is imitated in other places such as the United Kingdom where the unveiling of this statistic is placed on what is now dubbed “fat cat day.”

The problem with this statistic, just like any other statistic meant to incite indignation and grab headlines, is that it says absolutely nothing relevant. There are three reasons to be heavily dismissive of such a statistic including the dubious methodology used to make the calculations and the relevance of the interpretation made from the ratio.

Reason 1: Incorrect comparisons

In all of the studies of the sort, only a fixed number of top firms are selected. In the CCPA’s study, that number is 100. Given that Industry Canada places the number of companies in the country at a number of 1.17 million, this means the sample is equal to 0.009 per cent of all firms.

These firms are the top public firms in Canada. Firms that large are generally very productive and offer employees pay packages that are much larger than what the employee of the average firm obtains. Little information about the pay of employees in these top 100 firms is available, but we know that that firms with more than 500 employees paid their employees 23 per cent more than those with 0 to 4 employees in 2017. The CCPA compares the pay of these CEO with the pay of the average worker. In other words, it compares with the wrong employees. While this heightens the perception of a large gap, it’s an incorrect comparison.

A more proper comparison would be to take the average pay of CEOs for all Canadian firms and compare it with the pay of the average worker. When that’s done, using data from national surveys constructed by Statistics Canada, one finds that the average CEO earns 3.4 times what the average worker earns—a far cry from the figures found by the CCPA over the years, which hover between 190 and 220 times.

Reason 2: Confusion over what is “pay”

Another reason to be dismissive of such reports is that they tend to consider stocks owned by CEOs are part of their pay. While this is true on paper, it’s not economically correct to consider stocks as income. The income a person earns annually is a “flow variable.” The assets that a person owns, such as company stocks, are “stock variables.” As long as the stocks are not sold, they do not enter the flow of one’s annual income. The income stocks generate for a person only counts once they are sold.

As economist Steven Kaplan has shown, these stocks are often sold by CEOs who are fired by the board of directors once the firm has faced difficulties at which point the stocks are worth less than they were on paper a few years before. Since the CCPA takes the market value in any given year, they don’t capture the actual income earned by CEOs. As a result, they overestimate CEO pay.

Reason 3: Pay is (often) related to performance

Crucially, the ratio of CEO pay-to-employee compensation tells us nothing about the competence of the CEO. An implicit (sometimes it’s made explicit) assumption of reports such as the CCPA’s is that CEOs do not deserve to earn so much more than their workers. This is a strange assumption because it suggests that third-party observers have better knowledge of what constitutes the best pay package than the board of directors of a company that hires a CEO.

The reality is that top firms are generally innovative firms that can easily be dethroned by upcoming firms. Think of BlackBerry, a top Canadian firm in the early 2000s that was unable to compete with other innovative firms that replaced it. Think also about hotel companies, which are now locked in competition with platforms such as Airbnb. In such an innovative environment, even small errors by CEOs can be costly to a firm and its employees. Boards of directors must thus conceive the pay package that is most likely to attract the best candidates and incite in those candidates the greatest efforts.

Using a database of candidates to CEO positions that were both hired and rejected and which contained details about their individual skills, Steven Kaplan found those who were hired were more skilled. Thus, there was a strong relationship between pay and CEO skillsets.

Moreover, as noted by a recent Fraser Institute study, pay for the most sought-after athletes, actors and musicians follows the same pattern as CEO compensation. Simply put, there’s a global phenomenon regarding the compensation of top talent across sectors.

However, there are situations where we could be critical of the pay given to CEOs. For example, a CEO could be offered high compensation after successfully securing government subsidies (see Bombardier). However, in such an instance, blaming the CEO would amount to assigning blame to the wrong culprit. If a board of directors selects a CEO on the basis of his political acumen, which allows the firm to secure government subsidies, then the board of directors is selecting the right person. The culprit in this instance, however, is the government that created the incentive to hire politically-savvy officers by offering the subsidies in the first place.