Bridging the Pay Divide

The following post comes to us from Subodh Mishra, Head of Governance Exchange at Institutional Shareholder Services, and is based on an ISS white paper by Mr. Mishra, available, including appendix, here.


Investors have for a number of years expressed concerns over pay disparities between that of the chief executive officer and the next highest paid executive at U.S. corporations. The State of Connecticut pension system gave voice in 2008 to these concerns by filing shareholder proposals calling for enhanced disclosure of how internal pay equity factors into the pay-setting process. The targeted corporations were receptive to those concerns and agreed to implement the pension fund’s substantive demands.

Moreover, credit ratings agency Moody’s suggests pay gap multipliers in excess of three times the pay of the second highest paid officer can adversely affect a company’s cost of capital and debt rating. A high ratio between CEO pay and compensation for other named executives can indicate the company is CEO-centric, with associated CEO succession risk, according to Moody’s. [1] The ratings agency acknowledges that high internal pay equity can be a reflection of a CEO’s influence and centrality to a company, though argues “such a large disparity may indicate … concentration of power in the CEO.”

More recently, governance activists have focused on companies with significant pay gaps to warn over the potential for problems with succession planning. In their view, an excessive gap may suggest over reliance on one individual and failings on the part of the board to ensure the executive “bench” is stocked with capable talent that is able to step in upon the departure of a CEO.

Internal pay equity also is coming into focus as concerns mount over companies’ external peer benchmarking choices and processes (for more, please see ISS’ recent white paper, Executive Pay Through a Peer Benchmarking Lens). Critics contend current peer benchmarking practices exhibit deep flaws that have led to excessive pay, with some suggesting a greater focus on internal benchmarking as a potential remedy.

Moreover, a provision within the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act that calls for disclosure of CEO pay as a multiple of the average for that of rank-and-file employees will likely sharpen the focus on the pay divide between the CEO and all employees, including other named executive officers.

Note on Methodology

This analysis examined total direct compensation for the top five highest paid executives at Russell 3000 companies in fiscal years 2008, 2009, and 2010. Total direct compensation is defined as the sum of pay received from: base salary, bonus, non-equity incentive plan compensation, stock awards, option awards, change in pension value and nonqualified deferred compensation earnings, and all other compensation, such as perquisites. The calculation will generally match the Summary Compensation Table with the exception of the stock option value, the calculus for which can be found here.

The analyzed universe covered 2405 Russell 3000 companies in fiscal 2008, 2699 in 2009, and 2797 in 2010. For purposes of this analysis, the data set were refined further to exclude companies where the CEO was not the highest paid executive, reducing the universe to 1911 in fiscal 2008, 2146 in 2009 and 2209 in 2010. All data are drawn from ISS’ proprietary compensation database.

CEOs as Top Pay Earners

The CEO is not always the highest paid executive at a given corporation. For many market observers, the assumption of the CEO as highest paid executive is based on historical approaches to C-Suite compensation that often saw CEO pay packages dwarf those of the next highest paid executive.

Citigroup’s Sandy Weil, Morgan Stanley’s Philip Purcell, and Disney’s Michael Eisner are but a few prominent examples of a pay gap that was in past years more rule than exception. That gap was fueled in no small measure by awards of stock options and restricted stock to such CEOs.

But the proportion of CEOs as top paid executive began to decline following the mandatory expensing of stock options in 2005, and today hovers in the 80 percentage range for the full Russell 3000 index. Indeed, our analysis finds little change over the last three fiscal years, with CEOs accounting for 79.5 percent of top earners at study companies in 2008 and 2009, while dropping just slightly in 2010 to 79 percent.

The proportion of CEOs as top earners varied by index and sector, with 84 percent at large capital companies and 74 percent at Russell 3000 companies beyond the S&P1500. Across sectors, companies in industries that have done better weathering the financial recession over the past three years, including Materials, Energy, Industrials and Utilities, show a higher percentage of CEOs as the highest paid executive, as illustrated in Figure 1, and, critically saw less CEO turnover than other sectors such as Financials and Health Care.

Fig. 1: Percent of CEOs as Highest Paid Executive By Sector, 2010

Reasons as to why the CEO was not the highest paid executive varied. At some companies, other NEOs saw larger total payouts due to one-off transactions such as option exercises. At other firms, former CEOs, with substantial exit packages, saw total direct compensation well in excess of their successor. The latter was evidenced across all sectors and indices when analyzing a sample of companies where in fiscal 2010 the CEO was not the highest paid named executive. This may not be surprising when one considers the significant CEO turnover evidenced over the past three years.

Trends in Pay Proximity

Larger Companies See Greatest Gap in 2010

After discounting companies where the CEO is not the highest paid executive, our analysis found little change in the pay-gap multiple between the CEO and next highest paid executives from fiscal 2009 to 2010. As of fiscal 2010, larger companies were more likely to see, on average, the greatest pay gap between the CEO and next highest paid executive with S&P500 companies showing a multiple of 2.4 times and S&P MidCap firms at 2.3 times. At the other end, Russell 3000 companies outside the S&P1500 had an average multiple of just 2.1 while the full Russell 3000 index stood at 2.2 times.

The median multiple, meanwhile, similarly held steady between 2009 and 2010 at 1.9.

While little change is evidenced over the most recent two year period beginning in fiscal 2009, our analysis found a radical decline in the gap in total direct compensation between the CEO and next highest paid executive between 2008 and 2009. As illustrated below in Figure 2, the average multiple for all Russell 3000 companies dropped from 3.9 to 2.2, while that for the largest companies declined from 4.9 to 2.4. The median also dropped significantly across the full Russell 3000 index when in 2008 it stood at 2.6.

Fig. 2: Average Pay Multiple Separating CEO and Second Highest Paid Executive by Index, 2008 – 2010

At first glance, observers may be tempted to explain the shift by pointing to the financial crisis of 2008 and subsequent growth in investor demands to curb “excessive” pay packages, a tighter link between pay and performance, and the advent of “say on pay.” The numbers, however, suggest something more nuanced.

In fact, while average total direct compensation across the full Russell 3000 universe declined by 10 percent for CEOs from fiscal 2008 to 2009, the second highest paid executive saw, on average, a 53 percent increase in total direct compensation during the same period. At large capital companies, the trend is more pronounced, whereby CEOs at S&P500 corporations saw a 6 percent decline in total direct compensation from fiscal 2008 to 2009, but the second highest paid executive at those same firms saw an average pay increase of 82 percent.

To be sure, the financial crisis and resulting departure of highly paid executives in the Financials and other sectors served to help narrow the gap between fiscal years 2008 and 2009, but not to be overlooked was the concomitant spike in pay for executive chairmen, chief operating officers, and others that have traditionally held the number two spot on the corporate pay scale.

In fact, the spike may be attributable to various factors including a renewed focus on succession planning whereby total direct compensation for chief operating and financial officers, as well as other NEOs, was reevaluated and increased by boards seeking to retain top talent in the event of a CEO’s departure. Moreover, recruitment of high-caliber executives to serve as a strong number two may also have contributed to the trend as directors, following a number of high-profile CEO departures on the heels of the financial crisis, grappled with succession.

Prevalence of “Excessive” Multiples on the Wane

Underscoring the narrowing gap in total direct compensation between that of the CEO and next highest paid executive, as well as the efficacy of investor pressure to moderate pay levels in the immediate wake of the financial crisis, our analysis finds a significant reduction in outlier and “excessive” multiples, defined as greater than 10 and three, respectively, between fiscal 2008 and 2009.

Across the full Russell 3000 index, outlier multiples stood at 4.7 percent in 2008, dropping to roughly 1 percent as of fiscal 2009, and dipping further to well under 1 percent in 2010.

More notably, excessive multiples, again, defined as those in excess of three, saw a marked decline from 2008 when evidenced at more than one-half (53.6 percent) of companies across the Russell 3000. The proportion of problem multiples dropped to just 17.2 percent in 2009 and held at that rate for fiscal 2010.

Fig. 3: Percent of Companies with “Excessive” Multiples, 2010

Across sectors and indices in 2010, problem multiples were most evident at Materials companies where 29.3 percent of CEOs had pay multiples at or in excess of three times that for the next highest paid executive. Consumer Staples companies followed behind at 27.2 percent, while Consumer Retail firms stood at 23.7 percent. At the other end, just 8.8 percent of Energy company CEOs had a pay multiple in excess of three, while all other sectors were above 10 percent, as illustrated in Figure 3.

Larger companies were more likely to see problem multiples than smaller peers in fiscal 2010, with S&P500 companies including within their ranks 21.3 percent of CEOs whose pay multiple exceeded three times that of the next highest paid executive. The figure is more than four percentage points in excess of the study universe average.

A Shrinking Portion of the Pay Pie for CEOs

The portion of total direct compensation for the top five highest paid executives collectively that is awarded to the CEO shrank from 2008, further reflecting the trend toward narrowing the gap between the CEO and next highest paid executive.

As of fiscal 2010 and across the full Russell 3000, CEOs took home 42.2 percent of the total pay afforded the top five highest paid executives. The figure is just basis points less than in fiscal 2009, but significantly below the 56 percent evidenced in fiscal 2008.

S&P MidCap companies led the way among indices where CEOs consumed the greatest portion of the pay pie at 44 percent in fiscal 2010, while S&P500 held the title in 2008 at 61 percent.

By sector, Materials companies stood out in fiscal 2010 with CEOs in that sector accounting for 46.1 percent of pay of the top five highest paid executives, a 2.3 percentage point increase over 2009. Telecommunications company CEOs took home the least of the collective top five’s total direct compensation in fiscal 2010 at 39.2 percent.

As illustrated in Figure 4, Energy company CEOs, such as Occidental Petroleum’s Ray Irani and Exxon Mobil’s Rex Tillerson, took home 61.9 percent of the total pay pie in 2008, tops among sectors.

Financial service company CEOs, meanwhile, received among the lowest proportionally at just 54.4 percent in fiscal 2008, suggesting better C-Suite equity despite high-profile CEO pay days to the likes of JP Morgan Chase’s Jamie Dimon and Goldman Sach’s Lloyd Blankfein. And as Financial company CEOs pay dipped markedly or they lost their jobs to less well-paid newcomers, the proportion shrunk further in 2009 to just 39.3 percent.

Fig. 4: Proportion of CEO Pay of Total Pay for Top Five Executives, 2008-2010


While the pay gap between the CEO and next highest paid executive has narrowed significantly since fiscal 2008, problems remain that could raise red flags for investors whose focus on pay continues to sharpen. Specifically, more than one-fifth of all S&P500 companies maintain pay multiples between the CEO and next highest paid executive that may be deemed excessive by their shareholders, according to our analysis of ISS’ compensation database.

Moreover, as described in this paper, the narrowing gap between CEO and other NEO pay can be attributed in part to a sizeable increase in pay for the second highest paid executive over the past two years, perhaps stemming from a renewed focus on succession following the financial crisis. And as markets gyrate and companies continue to see near-record CE0 turnover [2], compensation committees would do well to evaluate C-suite pay disparity as part of preparations for the 2012 annual meeting season.


[1] Analyzing Credit and Governance Implications of Management Succession Planning; Moody’s Investors Service; May 2008.
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[2] More CEOs Out In September, Led By Health, Financial; Challenger Gray & Christmas; Oct. 12, 2011.
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