A manager in one division of a conglomerate receives a pay raise, owing to a particularly remarkable quarter in that division or a track record of strong performance that deserves financial recognition. So does it follow that a manager in another division of that same conglomerate should receive a raise as well?
In the absence of a strong governing board, in the presence of excess cash at a profitable company, and with managers who have influence over how that cash gets distributed, such raises are likely to happen, even if the divisions are unrelated, according to new research at Stanford Graduate School of Business.
Stanford GSB professor Amir Goldberg, along with Ran Duchin and Denis Sosyura, colleagues at the University of Washington and the University of Michigan, respectively, set out to examine the phenomenon called spillover—a general term in economics to describe events in one context that occur because of something else in a seeming unrelated context.
The researchers hand-collected data of divisional managers’ salaries at S&P 1500 firms, spanning 2000–2008. The goal was to figure out whether industry-level changes in pay influence that of divisional managers, not only in a manager’s division but in other divisions of the firm too.
The professors chose conglomerates for causal inference reasons—it’s easier to demonstrate causality in a conglomerate because such multidivisional firms operate in multiple businesses—but believe the findings extend beyond conglomerates. And, they believe, there are broader social implications as a result.
“The broader question our research speaks to is why are executives being compensated so much. Is it because they perform well and bring value to their firms or their stakeholders, or is it also because of luck?” Goldberg says. “And our answer is that, at least to some extent, executives get lucky. We find that when their peers get pay raises, these raises spill over to them, even if there is no economic rationale to justify that raise.”
That is particularly exacerbated when there is weak governance—and when executives have influence on, and proximity to, decision makers also suggests that the phenomenon is about who has power to distribute resources, and not who performs better and generates value for the firm.
When we interact with people and see them as socially similar, we humanize them and we are going to be less strict. For example, ‘George just separated from his wife and he’s refinancing the house and his daughter is in a rough patch’—so let’s give him a raise. But ‘Moira doesn’t care about the Giants and she doesn’t play golf’—so I’m not going to be inclined to humanize her and give her a pay increase.
Goldberg, an associate professor of organizational behavior, described a scenario using Disney as an example. In the imagined scenario, the amusement park business and the animation business are inherently intertwined—popular characters can be used as the basis for creating new rides and they can be used in creating future movies, which in turn could result in increased attendance at the amusement park. In that scenario, you would expect that if the pay for the division manager in the amusement division increased, it would also increase for the animation division manager, too.
But you shouldn’t expect to see an increase for a manager in a film division that produced more adult-oriented content, because the amusement park business and the film division producing mature content are not intertwined.
Yet the research shows that such compensation increases of managers in divisions that aren’t intertwined happen more frequently than not.
“You would expect salary spillovers to be most prevalent when divisions are highly dependent on each other,” Goldberg says. “But organizations aren’t efficient machines and it’s difficult to determine productivity efficiently, because companies are people with desires and relationships and aspirations.”
How does a manager in one division know about pay increases to a manager in an unrelated division? First of all, people talk, Goldberg says.
“And even if they don’t, even if division managers don’t know the dollar amount of the salary of their peers, they can make strong assumptions about it,” he says. “They’re thinking, ‘I’m pretty sure my friend is getting a huge bonus. I deserve a bonus too. I’m producing good content so why shouldn’t I benefit as well?’ ”
Studying the factors that amplify spillovers helps toward understanding their relationship to corporate governance and efficiency, according to the researchers. And that relationship is a huge and complex one. Another challenge in spillover, beyond the validity of managers getting raises as a result, is whether biases are also attached to those raises.
Goldberg uses another hypothetical to explain the relationship. In this scenario, three divisional managers are working for the same conglomerate. The first is a middle-aged white man who went to Harvard and likes to play golf. The second is also a middle-aged white man who went to Harvard and likes to play golf. And the third is an African-American woman who went to Wesleyan and likes to play basketball.
If the first manager gets a pay increase, the second is more likely to get a pay increase, while the third is not.
It’s difficult, Goldberg says, to put a number on how often this happens. Generally, the researchers found that as the number of potential connections between a divisional manager and his or her peers increases by 1 (for example, they went to the same school or are members of the same church) then the spillover effect more or less increases by 10%.
“We don’t know if companies do this consciously. It’s not [people] sitting in a room and plotting. We think about people through gender and race and age and ethnicity,” he says. “When we interact with people and see them as socially similar, we humanize them and we are going to be less strict. For example, ‘George just separated from his wife and he’s refinancing the house and his daughter is in a rough patch’—so let’s give him a raise. But ‘Moira doesn’t care about the Giants and she doesn’t play golf’—so I’m not going to be inclined to humanize her and give her a pay increase.”
The researchers found the spillover effect as it relates to divisional manager pay is enhanced when there’s weak governance in the firm. Goldberg says it’s important to have in a place a strong, independent governance where members of the board—especially those on the compensation committee—are not in “cahoots” with those people whose compensation they have to determine. Furthermore, it’s incumbent on CEOs and other C-level executives to diversify their management teams because this will reduce the risk of managers who reward their friends in the organization.
“There’s an immediate lesson in that managers get pay increases not commensurate with their contributions to the firm, but it’s also about lax governance as well as managers’ similarities to each other,” Goldberg says. “It doesn’t mean there shouldn’t be salary spillover, but you want to make sure that happens when deserved and not when managers wield influence to force it.”
This article originally appeared on Stanford Insights.