In this series of articles, we take a look at the business impact of the global divergence between the rich and the rest of society. In the first one, we examine what the rise in executive pay and income disparity means for corporate growth.

Across much of the world today, the slope to the top of the income pyramid keeps getting steeper. In the US, the top 1% in income now bring home almost a quarter of all income, up from about 12% in 1990, according to statistics of the Organization for Economic Co-Operation and Development (OECD). China too has seen more rapid growth at the top than at the bottom, to the extent that the top 5% of Chinese households take home about 23.5% of income, according to a recent survey of Chinese Family Panel Studies of Peking University.

CEOs have been particularly blessed everywhere, especially in the US. Between 1978 and 2012, the average CEO pay for the top 350 US firms rose by a whopping 875%, even as the wages of the typical worker rose 5.4% over the same period, according to data from the Economic Policy Institute, a Washington think tank. In 1978, the average CEO brought home 26.5 times more than the average worker. Today, the multiple has risen to 272.9 to 1. But Chinese chiefs looking for a plumper pay packet may not need to head east: compensation consultants ECA International estimate that if current rates of growth continue, Chinese executives will actually earn more in purchasing power terms than their American counterparts by 2017.

If that happens, will it be a good thing for China? Given that competitive markets have helped 600 million people pull themselves out of poverty over the past two decades, traditional laissez-faire capitalists might say further enriching this happy few would be a small price to pay if it helps a few hundred million more. However, a closer look at the consequences of “winner-take-most” compensation schemes suggests that companies may grow even faster if their compensation committees learn to say no.

Gordon Gekko was Wrong

In fact, Gordon Gekko, the ultimate poster child for greed on Wall Street, may have been wrong: greed doesn’t work. The evidence that what’s good for the boss is good for the business is actually relatively weak.

A recent study by MVC International, a management consulting firm based in Toronto and Tampa, found that the 18 Fortune 500 firms that paid the most to their top executives over a five-year period (GE, Boston Scientific, and Motorola topped the list) actually got surprisingly little for their money: none of the 18 produced a positive economic return above their cost of capital, and half also ended the period with a lower stock price than at the beginning.

High executive pay may also be expensive because it encourages excessive risk-taking. More than a few analysts have seen connections between investment banking’s bonus culture and the risky lending practices that led to the 2008 credit crisis and the end of Lehman Brothers and a number of other financial institutions in the US and the UK.

Of course, the vast majority of CEOs aren’t fearless gamblers, but the more cautious may also be hurting their company by focusing on the wrong thing. Current pay practices appear to encourage the CEO to focus on short-term operations instead of the higher-level long-term strategic thinking that actually creates value, according to Mark Van Clieaf, Managing Director of MVC International: More than 80% of the top 1,500 companies in the US lack a strategic plan that goes beyond three years.

The creation of a corporate star system may have other institutional ramifications as well. Over roughly the same period that most salary gains have flown upward, layers of middle management have been reduced. Many organizations saw flatter organizations as a way to save money and increase customer responsiveness and innovation by pushing more decisions to lower-level management. However, a recent paper by Julie M. Wulf, an associate professor at Harvard Business School, summarizing a number of studies she and several colleagues conducted over the previous decade, argues that reducing layers actually encouraged CEOs and upper level managers to spend more time on internal operational decisions.

The growth of the inward focus of the CEO went along with hikes in upper level functional managers’ pay. Meanwhile, division managers’ relative share went down. As pay and power tend to go hand in hand, Wulf and her colleagues theorize that more decisions are now being made at the top instead of nearer the front line. In the end, reducing hierarchy has had the ironic effect at many companies of making the firm more hierarchical.

This reduction in management opportunity may be having other knock-on effects too. Wulf writes that it is harder now for CEOs to groom talent because of the lack of clear promotional paths.

Anecdotal evidence suggests too that lower-level managers who see slim prospects for a real promotion may be less loyal. “Slimmer prospects for promotion make talent look increasingly outside,” says one somewhat frustrated middle manager at a major global company, in an interview.

Less commitment at the top has reduced commitment further down the ranks, the manager says, and increased movement between firms. “Unfortunately, the recent erosion of loyalty on both sides has led to an increasingly transactional relationship between companies and talent. Fortunately, sites like LinkedIn are out there creating excellent connectivity for such talent, which leads to greater percolation of talent within the industry,” he says.

Watch out for Falling Stars

Picking a few winners out of a pool can lead to other structural problems as well, not unlike creating a concentrated stock portfolio: if the stocks you’ve picked do well, you’ll outperform the market. But what if your winners don’t win?

One cautionary example of the downsides of star systems is the American law firm. US law firms once rarely went bankrupt. Traditionally, they could weather even extreme business cycles relatively easily. Partners shared profits but hired lower paid -and easily fired – associates to share the work. In hard times, fewer junior associates would be hired or more senior associates let go, but in the end, the firm would survive.

In recent years, however, many firms have tried to pay a more dangerous game, by trying to build business more quickly by recruiting seasoned partners, sometimes with pay guarantees. Such star systems widened pay differentials between lowest to highest paid partners from 10 to 1 to 20 to 1, and squeezed pay for junior and mid-level partners, according to an article by law firm consultants Patrick J. McKenna and Edwin B. Reeser in a June 2012 issue of American Lawyer.

But results have been mixed: 25 years after American Lawyer magazine’s first ranking of the top 100 law firms, 11 have become extinct, many because of the growing popularity of winner-take-most strategies.

Even when a star system doesn’t kill the firm, it may undermine productivity by making attorneys more competitive with each other and less likely to cooperate or work well as a team. “Partners begin to resent the lateral (and her pay), avoid her, cut off information to her, and—almost imperceptibly—refuse to cooperate and collaborate,” wrote McKenna and Reeser.

In the end, the firm becomes no more than the sum of its parts – and sometimes less. “Because the partnership lacks any shared cultural values or history, money becomes the core value holding the firm together,” William Henderson, a law professor at Indiana University who studies law firms, told the Daily Beast when one-time giant Dewey Ballantine neared an ignominious bankruptcy in 2012. “Money is very weak glue.”

Is There a Better Way to Set Executive Pay?

Even today, five years after the credit crisis damaged the credibility of a number of CEOs, public spats about particular executive pay packages tend to be rare.

Yet the humiliating public claw-backs of some executive bonuses in the United Kingdom after the credit crisis, the political resonance of the Occupy Wall Street movement’s rally against “the one percent,” and increasing shareholder activism all suggest that the days of the rock star CEO may be numbered.

So what should a company do if it wants to get ahead of the populist curve and make sure that its compensation policy boosts profits and not plutocrats?

• Think bottom-up. One rule of thumb for compensation committees might be to look toward the part of the company where pay seems more efficient. Van Clieaf says that 13 studies conducted over 60 years have found that on average, each layer of management creates 2-2.5 times more value than the previous layer. Do the math and this implies that a seven-layer company with a $120,000 line manager should pay its CEO no more than $11 million, according to Van Clieaf.

• Trim stock options. Theoretically, the idea of paying someone based on the performance of stock might seem sensible, but a number of experts have noted that they tend to be dispensed without a real sense of what those options will eventually cost the company, and CEOs often profit more from general market surges than the results of their own acumen.

• Kick out cronies. In the US, compensation committees are often made up of colleagues at other companies and board members (including CEOs of other companies). A number of critics say that most members see the CEO as a peer or a customer, and are likely to go along with the CEO’s request.

Changing the compensation-setting process might help. In Germany, for instance, CEO pay is much lower. One reason may be that workers’ representatives are part of executive pay discussions. Robert Locke, a scholar of comparative management and Emeritus Professor at the University of Hawaii at Manoa, speculates that the presence of workers on these committees may make a pay request more uncomfortable for the CEO. “If you have employee representatives sitting on [the committees], they’re much less likely to give top money to top management,” he says.

Ask Not What your Company Can Do for You…

For Van Clieaf, the key question for companies to focus on is not the absolute dollar amount but on what they want the executive to accomplish. Current pay practices keep CEOs focused almost entirely on the next three years, he says, because their rewards are geared to encourage them to keep sales climbing now and plumping the current stock price, leading them to focus on yesterday’s cash cow.

To encourage more strategic thinking, he suggests that companies should follow the lead of 3M and Intel: measure the revenue growth of new products and new markets introduced within the past five years and the five-year average return on invested capital. “Instead of asking how much?” Van Clieaf says, “compensation committees should ask, for what?” Rather than peg their pay to the stock price and market shares or revenue–all of which tend to reflect the current state of the business–CEOs should be encouraged to do the job that they are best positioned to do: thinking strategically about the company’s future.

“That is the executive work that we really need to be paying these people for and that’s what justifies pay differentials of 60-100 times the front line manager’s,” Van Clieaf says.

(Image courtesy: Flickr user epSos.de’s photostream)