Much of the discourse on income inequality between ordinary workers and top executives concentrates on a ratio of chief executive officer (CEO) compensation to average employee compensation. The business strategy, organizational structure, and size of a firm can influence the numerator and denominator of this ratio, leading to misinterpretations of a firm’s level of income inequality.

Absent from the income inequality debate is the link between compensation and level of responsibility. Generally, managers earn more than their direct subordinates, and promotions with an increase in responsibility come with a corresponding increase in compensation. The firm’s underlying compensation system dictates the pay difference between superiors and subordinates and the amount of a raise that comes with an increase in responsibility. Firms compensate for greater responsibility in one of three basic ways:  (1) increase by rising percentages (a 10 percent raise, followed by a 12 percent increase, followed by a 13 percent increase and so on), (2) increase by a declining percentage (a 20 percent increase followed by a 19 percent raise followed by an 18 percent increase and so on), or (3) increase by a constant percentage (each promotion is rewarded with a 12 percent increase in compensation).

In a recent study, I develop an empirical measure to capture the underlying compensation system structure of the firm and assess the relative effectiveness of the three compensation system structures in improving firm performance. I measure compensation system structure through the promotional pay ladder (PPL), defined as the relationship of percentage increases in compensation corresponding to increases in the level of responsibility held by an employee.

Due to data availability limitations, I perform the main analysis using the S&P 500 for the years 2007-2012 and measure future firm performance as return on assets (ROA) and abnormal stock returns (BHAR) up to three years in the future. Using regression analysis, I find that compensation systems with unequal percentage increases relative to increases in responsibility are associated with lower future firm performance. Deviations away from a compensation system structure with consistent percentage increases in compensation as an employee advances up the hierarchy seem to affect different groups of employees and have different effects on future firm performance.

Firms with a structure that increases compensation by a rising percentage are associated with lower ROA one and two years out and on a three-year average. These firms also exhibit lower three-year abnormal stock returns. Firms that compensate increases in responsibility with  declining percentages are associated with lower levels of one and two-year abnormal stock returns.

A structure that increases compensation by rising percentages could lead employees at the lower ends of the hierarchy to feel under compensated, prompting them to reduce their effort to the level of their compensation and make operations less efficient. The findings of my study imply that the alienation of the lower levels of employees results in less productivity and a lower return on assets. An extended period of lower return on assets appears to result eventually in lower abnormal stock returns.

Conversely, a system that increases compensation by declining percentages could lead employees at the higher ends of the hierarchy to feel they are under compensated and cause them to reduce their effort to the level of their pay. These executives might be less motivated to allocate the resources of the firm effectively, resulting in the firm’s failure to capitalize on its strengths and abilities. The findings in my study imply that reduced effort from unmotivated executives results in reduced abnormal stock returns. Over time uninspired managerial decisions also appear to reduce average ROA.

My study provides a unique method to identify the compensation system structure of a firm and its relationship with future performance. Additionally, my study extends research into how compensation motivates employees with a new focus on not just top executives but all employees. My study also provides evidence that in a modern economy, non-executive employees are critical assets for a firm.

This post comes to us from Professor Hamilton Elkins at the University of Saskatchewan’s Edwards School of Business. It is based on his recent article, “Measuring Compensation System Structure: The Interrelation Between Equitable Pay and Firm Performance,” available here.