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Pay Well, But Not Too Well

Matt Palmquist

Matt Palmquist is a freelance business journalist based in Oakland, Calif.

 

Bottom LineWhile compensating managers generously might induce more of them to stay, paying anyone too much can upset the balance of the executive suite.

Retaining managerial talent is a vexing challenge for firms around the world. A global survey of more than 800 CEOs recently showed that holding on to key managers was the top worry of chief executives in Asia, and the sixth and seventh leading concern for their European- and U.S.-based counterparts, respectively. It’s widely assumed that paying employees more will persuade them to remain with a company. But a new study reveals that the reality is far more nuanced: it’s not just a manager’s own paycheck that factors into his career decisions, the authors found, but also how his compensation stacks up against that of his colleagues, both at the same company and at competing firms. And in a counterintuitive twist, paying top executives too much can actually be one of the most effective ways to make them jump ship.

Most previous research on executive compensation has focused on CEOs, largely ignoring the vice presidents (VPs) who work directly below the chief executives and comprise the firm’s nucleus of strategic decision makers. This study aims to shed light on this vital group, examining how inequalities in pay affect the turnover level of VPs at some of the largest firms in the United States.

The authors analyzed almost 3,000 executive turnovers at S&P 500 companies during a recent 11-year stretch. More than 2,100 of these were voluntary moves, as opposed to forced firings as a result of poor performance or acquisitions by other firms. The authors meticulously collected data on both how many managers left a particular firm and the circumstances under which an individual VP chose to resign, controlling for variables like fluctuation in firm performance relative to industry peers.

Overall, the analysis showed that firms that pay their VPs more, relative to the industry average, generally seem able to keep them. But large inequalities in compensation, both within their own ranks and relative to managers at competing firms of similar size and sales strength, led to higher rates of VP exodus, implying that relative pay (and not just total compensation) can also be a powerful determinant of a manager’s career decisions.

Companies that named a successor to their current CEO, or had recently appointed a new chief executive with strong ties to shareholders, also saw more VPs step down. Presumably, the authors reason, any pay disparity between a new CEO and the VPs is not viewed by managers as a source of motivation, but as a definitive confirmation of their lesser status and pay grade. In these contexts, when a new CEO—whether appointed from inside the company or outside of it—stands to earn much more than they do, VPs are more likely to flee.

And while VPs generally stick around longer at higher-paying firms, merely earning more isn’t enough to guarantee an unshuffled executive suite: the most handsomely rewarded individual VPs are also the most likely to leave. That’s because a large paycheck can alert rivals of a manager’s talent, the authors note, thereby opening up more lucrative opportunities for that manager on the open market.

A large paycheck can alert rivals of a manager’s talent.

And where do these managers go when they’ve left a firm they think has unfairly (or too fairly) compensated them? Using a smaller subset of VPs whose career movements could be tracked from company to company, the authors found that 40 percent of them became CEOs at new firms, which were often much smaller and in a different industry. The second-highest paid VPs in their previous jobs were most likely to step into the CEO role, whereas the fourth-highest paid generally stayed on the VP track when moving to a new company. This supports the authors’ earlier contention: VPs who earn more are typically regarded as highly capable by competitors and have better employment options as a result.

So compensation becomes a delicate proposition. Firms should seek to pay their managers competitive salaries, in terms of both their own finances and those of their competitors, but they risk losing their top talent if their increased compensation tips off other companies to the presence of a budding superstar executive in their ranks. Of course, pay isn’t the only factor in retaining executives; the authors also found that turnover occurs less frequently at larger, more profitable companies with older CEOs and top management teams. But to maximize the value of their top executives, firms should strive to arrive at a formula that uses pay inequality levels to spur on the performance of their junior VPs and reward established managers, while always making sure that compensation generally remains aligned within the firm and the industry standard.

Source: Pay Inequalities and Managerial Turnover, Jayant R. Kale (Northeastern University), Ebru Reis (Bentley University), and Anand Venkateswaran (Northeastern University), Journal of Empirical Finance, Jun. 2014, vol. 27

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Pay Well, But Not Too Well