Winning the rat race: The effect of peer salaries

Winning the rat race: The effect of peer salaries  

April 9, 2024 | By Professor Ron Kaniel 

In this blog post, Professor Ron Kaniel explains why relative compensation matters and why wage transparency requirements can backfire.   

In economics, contract and incentive theory seeks to uncover what motivates employees to perform at their peak. Crack that code, the thinking goes, and you can design a system of incentives that gives organizations a leg up over their competition. But when it comes to negotiating employment contracts, the gap between economic theory and the reality on the ground can be stark—and the difference lies in human nature.

 In “Contracting in Peer Networks,” my co-author and I take a deep dive into how people consider their compensation in relation to their peers when entering into a contract. We had previously examined, together with another co-author, the impact of relative wealth considerations on things like portfolio choice decisions and asset pricing, showing they can play an important role in explaining the home bias puzzle, existence of financial bubbles, and over-investment. A natural next step was to extend this line of thinking to employment contracts.

What theory tells us

From existing research, we know several things about compensation:

You can’t observe the effort an employee actually exerts, only the final output.

If I’m in charge of hiring and evaluating a CEO for a company, I approach the process of creating a contract with a basic fact in mind: There is no one-to-one mapping between the amount of effort that CEO exerts and their work output. Ultimately, output is a combination of effort and external factors. For example, during the tenure of a CEO of an oil company, increasing global oil prices will make the company more profitable, unrelated to the CEO’s efforts. There are all sorts of events—political elections, natural disasters, unforeseen market events, etc.—that create noise when I’m trying to gauge the CEO’s actual performance. 

Relative performance theory (RPE) tries to account for the noise. 

There is a large body of literature that recommends using relative performance evaluations (RPEs) to reward employees only for the output that can be linked to their own performance, not just overall output that could be linked to any number of factors. In theory, I should create a contract that looks at the average of how similarly situated CEOs have performed and reward the CEO based on output relative to peers. If my CEO is producing a greater output than peers, that is a sign that I should compensate the CEO more. If that output is less, I should compensate them less. Essentially, I want to control for the outside factors that constitute noise when it comes to a CEO’s output. 

Theory vs. reality

In the real world, many contracts are not structured as theory would suggest.

Empirical evidence suggests that actual contracts are not structured in a way that RPE theory predicts. Take a scenario in which a CEO increases output by 25%, in line with others in the industry. Then consider a second scenario in which that CEO increases output by 25% but the rest of the industry increases output by 50%. RPE theory predicts that that the CEO will be compensated less in the second scenario, to reflect the fact that their individual relative performance was not as strong as in the first scenario. But in real life, in many cases the CEO is compensated more in the second scenario. The rising industry tide lifts all boats. 

Motivated by the discrepancies between theory and practice, my co-author and I began to explore the idea that CEOs are motivated by their wages in relation to peers, not just their absolute wages, and examine its implications for the contracts they receive. 

Below, I share some of the conclusions we reached. To read the full paper, click here. 

Accounting for peer effects generates more efficient contracts. 

A CEO may outperform their peers at some times and underperform in others. A higher base pay can mitigate dissatisfaction in those cases where they would have been paid less than peers based on performance, but that higher base pay is inefficient in that it keeps pay high in situations where the CEO is already satisfied with the state of things. Instead of increasing the base pay, a more efficient contract is one that directly targets those situations in which the CEO underperforms peers, and thus is most likely to be dissatisfied about their compensation relative to others.

The peer effect leads to a rat race. 

The CEO I hire has an incentive to exert more and more effort, not just because they will get paid more but because they will experience the satisfaction of feeling like they are compensated more highly than peers. Unfortunately, this mentality leads to overexertion of effort. When one CEO works harder, their peers take notice and ramp up their own efforts, which ends up raising the bar for everyone. Consequently, all CEOs exert too much effort, their compensation goes up faster than output, so the firm experiences reduced profits as a result. 

Disclosure requirements only amplify the problem.

In a bid to improve transparency, the SEC introduced wage disclosure requirements so that the contracts of high-level managers are now publicly available across firms. This has only amplified the problem. Firms that write contracts realize that their company’s performance can impact the compensation of other CEOs, impacting the satisfaction of their own CEO and raising the cost of compensating them. Instead of tamping down on CEO pay as intended, disclosure requirements actually increase overall CEO pay and cut deeper into firms’ profits. 

When it comes to understanding the motivation of high-level employees, classic economic theory breaks down. In real life, the average CEO is keenly aware of how their peers are performing and what they are earning. The effort to win the rat race or “keep up the Joneses” is not just an interesting social phenomenon—it’s a dynamic with significant implications for performance, profits, and regulation. 

Ron Kaniel is the Jay S and Jeanne P Benet Professor of Finance at Simon Business School. 

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