Prestige, Promotion, and Pay

Daniel Ferreria is a Professor of Finance at the London School of Economics and Political Science, and Radoslawa Nikolowa is an Associate Professor of Economics and Finance at Queen Mary University of London. This post is based on their article published in The Journal of Finance. Related research from the Program on Corporate Governance includes The Growth of Executive Pay by Lucian A. Bebchuk and Yaniv Grinstein; The CEO Pay Slice (discussed on the Forum here) by Lucian A. Bebchuk, Martijn Cremers, and Urs Peyer; and Paying for Long-Term Performance (discussed on the Forum here) by Lucian A. Bebchuk and Jesse M. Fried.

CEOs, corporate executives, managing directors in investment banking, and partners in law firms are all positions that are considered prestigious. They are also highly paid. This bundling of prestige and pay is a common feature in many high-level jobs. Specifically, in professional services firms, being promoted to managing director or partner usually results in an increase in both pay and prestige.

There are good reasons why prestigious jobs pay more. After all, we expect those promoted to top positions to be highly talented, and top talent is scarce. Still, since most people enjoy being promoted to a prestigious position, why do firms need to pay so much more to those at the top of hierarchies?

In Economics, the traditional framework for thinking about jobs with desirable (or undesirable) characteristics is the theory of compensating differentials. In The Wealth of Nations (Book X, Part I, 1776), Adam Smith writes: “Honour makes a great part of the reward of all honourable professions. In point of pecuniary gain, all things considered, they are generally under-recompensed.” According to this logic, employees should be willing to “pay” for desirable job characteristics by accepting lower financial compensation. Thus, all else constant, prestigious jobs should pay less. In the article “Prestige, Promotion, and Pay,” published in The Journal of Finance, we argue that when firms design internal careers to attract potential employees, prestigious jobs should pay more.

We consider a situation where firms must fill positions in prestigious jobs, such as partner positions in finance, accounting, or law. Our fundamental assumption is that employees perceive the prestige of a job and its monetary compensation as complements. That is, a more prestigious position requires higher financial compensation. This is an old idea. In his classic study of status in the workplace, George C. Homans argues that “by emotional logic, if one job is better than another, it ought to get better pay” (see Homans, G. C., “Status among clerical workers,” Human Organization 12, 1953, p. 9). Building upon this assumption, we present a model in which firms optimally design internal career paths by creating several less prestigious entry-level jobs. All employees initially work in such jobs, but only some are later promoted to more prestigious ones. That is, optimal career paths resemble promotion-to-partner structures in which entry-level employees (“associates”) compete for a limited number of better-paid and more prestigious positions (“managing directors” or “partners”), as observed in many financial and other professional services firms. Wages increase upon promotion, and the top jobs offer high prestige and monetary compensation. 

Our model has several new empirical predictions that link prestige, pay, and career profiles. The associates-to-partner ratio is larger for more prestigious top jobs, resulting in lower promotion probability but higher pay upon promotion. This result has implications for career paths both within and across firms, as well as across sectors.   

In firms, we expect to see a higher number of associates per partner in departments that are associated with higher-prestige activities. This observation is supported by empirical evidence showing that corporate law and litigation departments, which are perceived as having higher status, tend to have larger ratios of associates to partners than departments dealing with less prestigious matters. (See, e.g., Rebecca L. Sandefur, Work and honor in the law: Prestige and the division of lawyers’ labor, American Sociological Review 66, 2001, 382–403.)

Our model also predicts that firms with higher prestige will offer higher wages at the top, consistent with Harrison Hong and Jeffrey Kubik’s findings that “security analysts’ wages at top-tier brokerage houses are substantially higher than at lower-status houses.” Finally, our paper provides a possible explanation for the steeper pay profiles observed in financial careers, which are often perceived as offering a large number of prestigious jobs.

The existence of high-paying and prestigious jobs can have significant implications for the allocation of talent across different industries. Industries that offer highly prestigious jobs tend to create more entry-level positions. However, this may lead to a misallocation of talent in the sense that sectors with more prestigious jobs may grow too large. This happens because companies in high-prestige sectors often poach workers from industries that have high social value but low payoff contractibility. Therefore, our model provides a possible explanation for the common view that the financial services industry is inefficiently large.

Our theory provides a solution to the paradox of pay and prestige. While the monetary prize for winning a promotion is larger when the promotion leads to a more prestigious job, prestigious careers are still underpaid in Adam Smith’s sense. For entry-level employees, career paths are lotteries: while a few enjoy significant increases in pay and prestige, the majority end up in less prestigious jobs with moderate income. Young professionals are nevertheless willing to take such risks because the complementarity between pay and prestige makes the prize too tempting. Thus, careers in prestigious occupations are still “underpaid” on average. Again, Adam Smith would have agreed: “The lottery of the law, therefore, is far from being a perfectly fair lottery; and that, as well as many other liberal and honourable professions, is, in point of pecuniary gain, evidently under-recompensed” (The Wealth of NationsBook X, Part I).

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