In today's Finshots we look at the debate surrounding overpaid CEOs and underpaid employees

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The Story

If you’ve been following recent headlines, you’ve probably heard about Infosys CEO Salil Parekh and the massive salary hike he received this year. A whopping 88% hike over the previous financial year with his annual compensation now standing at a staggering ₹80 crores.

It’s kind of insane and it has got some people talking.

What did Parekh do to deserve all the love?

Well, in the words of Infosys, “Under his leadership, the total shareholder return (TSR) was an impressive 314 per cent, the highest among peers. Revenue has grown from Rs 70,522 crore (fiscal 2018) to Rs 1,21,641 crore (fiscal 2022), a compound annual growth rate of 15 per cent (versus nine per cent for the four years before that)…”

And in totality, it seems he did a better job than his predecessor. He outperformed his peers. And he was able to create massive wealth for the shareholders in the past 4 years. So the annual compensation makes sense.

Also,  there is a caveat — fixed pay will account for less than 15% of Parekh’s total new compensation. The rest is variable — linked to his performance. He will likely have to show better revenue, better profits and transition into new business segments. Maybe even improve other qualitative metrics — Employee attrition and all that. And if he does hit all the benchmarks, he will then likely be awarded more money in cash and equity i.e. company shares. So in effect, if the company does well as a whole, his shares will also be worth a tidy sum of money. And when you think about it, you’ll realise that this is more about aligning objectives.

But even then, some people will argue that the compensation is obscene in its extravagance. It’s crazy that a CEO gets paid this kind of money when workers are still trying to make ends meet. Take for instance the CEO-to-worker pay ratio. Parekh’s compensation, including stocks, is a massive 872 times the company’s median pay! Even if you exclude the stocks, it’s still 229x the median salary. And it isn’t just limited to Infosys. CEOs in private sector companies across  India make 137 times more than their median employee. In the IT sector, CEO pay is 141 times higher than the median pay. In the Pharma sector, we see a multiple of 238.

Globally too, we see the same story unfold. The CEO-to-worker pay gap has expanded exponentially over the past few decades. During the 1970s, the average CEO in the US made 31 times more than the typical worker. That jumped to 61 times by 1990. By 2020? Well, you better sit down for this — it was a staggering 351 times higher!!! And some studies show that this burgeoning inequality leads to high attrition, low levels of employee satisfaction, and even lower sales.

So policymakers are now deliberating on whether to rein in this inequality. They’re considering capping CEO salaries to improve outcomes.

If you’re reading this, you will most likely agree with this assessment. You’ll likely concede that there’s absolutely no reason why CEOs should get paid these obscene amounts of money while employees continue to scrape the bottom of the barrel.

However, this thinking has some flaws. For instance, consider a cricketing analogy. As a batsman, Virat Kohli gets paid disproportionately more than his peers trying to ply their trade in Ranji cricket. Both cricketers try and hit a ball with a piece of willow and yet there’s this massive gap in pay. In fact, over the years, this inequality has only exacerbated some more. But if you think about it, you can see why this is happening. Elite cricketers are a step above “good” cricketers. And the market for elite cricketers looks very different when compared to the market for just “good cricketers.” There just aren’t enough people who can do what Virat Kohli does on a daily basis. And since cricket lovers are willing to pay a premium for quality entertainment, Virat Kohli continues to get paid the big money.

Now some of you will look at this and go — “Well, his performance doesn’t warrant this kind of money. At least based on current form.” And you’d have a point. But then, the market will also account for this anomaly. If his form continues to deteriorate some more, it’s unlikely he will be able to pull the same kind of money from his cricketing pursuits. Somebody will replace him — as people do in a system based on meritocracy. And this is what free-market economists believe.

The market for CEOs is tiny. You just don’t have enough people who can consistently do what these top professionals do. So it’s natural they get paid a sum that reflects their ability. In fact, some studies show that capping CEO salaries can in fact have an adverse effect on employee outcomes.

After China imposed pay restrictions on CEOs of Centrally Administered state-owned enterprises, the top-level executives simply increased the consumption of perks and siphoned off firm resources for their own benefit. The performance of these firms also dropped following pay restrictions and affected both hiring decisions and employee pay.

Even simple disclosures about pay ratios can have unintended consequences. For instance, one researcher argues that — “A CEO wishing to improve the ratio may outsource low-paid jobs, hire more part-time than full-time workers, or invest in automation rather than labour. She may also raise workers’ salaries but slash other benefits.”

So clearly it’s not just as simple as capping CEO salaries or forcing them to improve the “CEO-to-worker” pay ratio. What we really need is reform to ensure that CEOs have the right incentive to create value that will help elevate the salaries of everyone, not just their own.

How do we do that? Well, maybe that’s a story for a different day.

Until then…

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