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Some of America’s fat cat CEOs are going on a diet — and maybe you should too.
Amid a slowing economy, layoffs and the most-anticipated (potential) recession in United States history, the chief executives of major companies are facing slimmed-down pay packages. Zoom CEO Eric Yuan announced in a blog post that he would “show accountability” for poor results by taking a 98 percent salary cut and forfeiting his annual bonus. Other corporate bosses in for big pay cuts include Apple’s Tim Cook, Morgan Stanley’s James Gorman, Google’s Sundar Pichai and Intel’s Pat Gelsinger.
But all of this humbling begs a question for business owners: Does cutting executive pay actually benefit your business or is it merely good public relations? Let’s take a closer look.
>> Read next: Don’t Want to Cut Employees? Try Cutting Salaries
The pros of cutting executive pay
A few studies have shown that cutting managers’ pay can benefit a business during tough times. For example, a 2022 paper from the WU Vienna University of Economics and Business found that voluntary executive pay cuts can increase productivity among lower-level employees. The authors wrote that the effect was particularly strong when managers donated their salary to social causes or used the money to give back to employees.
An earlier study published in the Journal of Corporate Finance also showed a pronounced increase in company profitability following a decrease in CEO pay. The researchers theorized that pay reductions likely incentivized executives to reduce debt, cut spending and improve overall results. Indeed, merely lowering the CEO’s pay produced the same outcome as replacing the CEO entirely.
Other ways to keep employees happy during tough times include embracing staff feedback and hosting team-building events.
What could explain these results?
For one, voluntarily cutting your pay demonstrates empathy with your employees and that you put your people first. It also underscores the idea that you have skin in the game and that everybody does well only when the company as a whole does well. Notably, the positive effect of a voluntary executive pay cut on employee morale holds regardless of the gap between the CEO’s pay and the average employee’s pay, according to the WU Vienna study. This can help companies retain talent and prevent turnover contagion.
Given the size of many CEOs’ pay packages, cutting executive salaries can also sometimes help save rank-and-file employees from layoffs. Your workers would likely get behind that idea: A recent survey from consulting firm Gartner found that 77 percent of employees believe that the top dogs should forgo their salaries if it means avoiding layoffs.
Although nobody likes taking a hit to their paycheck, generating cost-savings by cutting salaries instead of employees is a strategy worth considering. Make sure you know the laws and guidelines on salary reduction before taking action.
The cons of cutting executive pay
In theory, docking the boss’s pay should incentivize better decision-making among the C-suite. But it doesn’t always work that way.
In 2018, Northwestern University professor Swaminathan Sridharan looked into executive pay cuts and found that this move can backfire. More often than not, extreme pressure to perform amid salary reductions causes executives to fudge accounting and make self-serving decisions. This practice of “managed earnings” can fool investors and analysts into believing that a company is improving, which boosts the share price.
Smart ways to recession-proof your business that don’t involve cutting pay include managing your cash flow and maintaining a healthy level of debt.
Because executive pay is often tied to a company’s stock price performance and Generally Accepted Accounting Principles earnings, CEOs are incentivized to take actions that will generate market enthusiasm over the short term. Examining nearly 20 years of data where CEO pay was cut by at least 25 percent, Sridharan and other researchers found a marked increase in both earnings management and accounting shenanigans. This resulted in a lower return on assets, a measure of how productively a company uses its capital.
What about the other papers that showed increased profitability following CEO pay cuts? Sridharan remains skeptical of those studies, speculating that the so-called improvements were simply the result of short-termism and managed earnings.
How do CEOs manage earnings?
One way that executives manipulate earnings is through clever accounting. This can involve timing certain expenditures or selling an asset in such a way as to show increased earnings. Another method is to cut discretionary expenses such as research and development (R&D) and advertising or cull a fixed percentage of the workforce.
In the short term, these actions can produce immediate results and generate increased earnings, but they aren’t sustainable. Over the long term, decisions like cutting the R&D budget can erode a business’s competitive position while cutting back on advertising can kill growth and customer acquisition.
Maintaining robust internal controls can help your business prevent accounting fraud by employees.
Cutting your pay the right way
Taking a hit to your paycheck or reducing your managers’ pay can be an effective strategy during lean times. But you need to do it for the right reasons and the right way. Follow these best practices.
Don’t force pay cuts.
The evidence uncovered by Northwestern’s Sridharan shows that imposing pay cuts on management as a punishment for poor company performance only incentivizes more bad behavior. Moreover, involuntary pay cuts do nothing to improve morale and employee perception of the C-suite. If your workers believe that executive pay cuts are nothing but a cynical publicity stunt, then they could easily have the opposite effect of strengthening productivity and manager-employee relations.
Take a voluntary salary reduction.
Make sure you or your managers communicate to employees that your executive pay cuts are voluntary so they realize the sacrifice the C-suite is choosing to make. An even more effective strategy is to redistribute that cut executive pay among your employees, donate it to a social cause or use the savings to avoid layoffs.
Although cutting executive pay in a large company is often more of a symbolic move than an actual source of cost savings, the intangible benefits can be significant. After all, feasting at the trough while your employees suffer during bad economic times is a great way to create a PR nightmare.
Making tough financial decisions
Eventually, every business owner or manager will need to make some unpopular financial decisions for the good of the business. Sometimes, that means taking away popular employee perks or knowing when it’s time to fire an underperforming employee. Whatever the case, it helps when you also share in the pain by cutting your own paycheck. Such a gesture, when well-executed, helps your company ride out the storm, and you can make up for the reduction later on when business improves.