CEO Compensation: Evidence From the Field

Alex Edmans is Professor of Finance at London Business School; Tom Gosling is an Executive Fellow at London Business School; and Dirk Jenter is Associate Professor of Finance at the London School of Economics. This post is based on their recent paper. Related research from the Program on Corporate Governance includes the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, Executive Compensation as an Agency Problem, and Paying for Long-Term Performance (discussed on the Forum here), all by Lucian Bebchuk and Jesse Fried.

In our paper, CEO Compensation: Evidence from the Field, which was recently made available on SSRN, we survey over 200 directors of FTSE All-Share companies and over 150 investors in UK equities on how they design CEO pay packages: their objectives, the constraints they operate under, and the factors they take into account. The answers reveal several interesting results that challenge existing academic theories, which we organize into three groups:

Objective and constraints

We first ask respondents to rank the importance of three goals when setting CEO pay. 65% of directors view attracting the right CEO as most critical, while 34% prioritize designing a structure that motivates the CEO. For investors, these figures are 44% and 51% respectively. This reversal reflects a theme that recurs throughout our survey—directors view labor market forces, and thus the so-called “participation constraint”, as more important than investors, who prioritize the “incentive constraint”. Only 1% of directors and 5% of investors view keeping the level of pay down as their primary goal. This is consistent with CEO pay being a small percentage of firm value, while hiring a subpar CEO or providing suboptimal incentives has potentially large effects.

However, boards feel restricted by far more than the participation and incentive constraints focused on by standard models. 67% of directors admit that they are willing to sacrifice shareholder value to avoid controversy on CEO pay—from parties such as proxy advisors, employees, and customers. Surprisingly, the strongest constraint is the need to obtain investor support, even though this should be automatic if boards are setting pay optimally. Instead, directors believe that shareholder guidelines, paradoxically, harm shareholder value. 77% report that such constraints have forced them to offer a lower level of pay, and 72% an inferior structure.

Most models of CEO pay take the “shareholder value” view that pay is set by a single principal, a shareholder-aligned board. The main alternative is the “rent extraction” view, whereby boards are captured by CEOs and thus do not seek to maximize value. However, our free-text fields and interviews suggest a third perspective—directors and investors share the same objective (shareholder value), but view the world differently. One possibility is that directors better understand the CEO labor market, whereas shareholders push for changes that would violate the CEO’s participation constraint or demotivate her. Another is that boards overestimate the value of their CEO or underestimate their latitude to improve pay.

To help disentangle these interpretations, we ask the 77% of directors who were forced to offer lower pay about the consequences. While 7% report that the CEO left, and 13% that they hired a less expensive CEO, 41% admit that there were no adverse effects. This result is meaningful, since any self-serving bias would discourage this response. Thus, at least in some cases, boards overestimated the negative consequences of tough decisions on CEO pay. However, 42% reported that the CEO was less motivated, suggesting that the level of pay affects incentives, in contrast to standard theories.

Incentives and variable pay

There is greater agreement on the second set of questions—the role of financial incentives in motivating CEOs. Both boards and shareholders believe they are relevant but of secondary importance. The CEO’s intrinsic motivation and personal reputation are seen as most important, yet are absent from nearly all theories. However, financial incentives still matter, because they reinforce intrinsic and reputational incentives. CEOs believe it is fair to be rewarded financially for good performance; perceived unfairness would erode their intrinsic motivation. As one respondent stressed, “the retrospective acknowledgement of exceptional performance is important.” Separately, an increase in realized pay signals the CEO’s performance to outsiders, boosting her reputation.

These responses suggest that incentive pay may work through different channels to standard models. In these models, the CEO only improves firm value if her utility from consuming the resulting pay increment exceeds the effort required to do so—the contract offers sufficient consumption incentives. Our respondents instead suggest that variable pay provides ex-post recognition. A CEO does not need the extra pay to finance consumption, but believes it is fair to be recognized for a job well done.

The importance of ex-post recognition has two implications. First, it suggests that a CEO assesses her pay not only for the consumption utility it provides, but also against her expectation of a fair reward. This expectation is believed to be affected by at least two reference points—the CEO’s contribution to the company and the pay of her peers.

Second, flow pay plays a special role not provided by the CEO’s equity stake. In standard theories, only total incentives matter—it is irrelevant whether they stem from changes in flow pay or the value of the CEO’s equity. Empirically, incentives from equity holdings are much greater, so standard measures of CEO incentives ignore flow pay. However, changes in flow pay provide greater ex-post recognition, because they require a discretionary decision by the board and are voted on by shareholders. They are also publicly disclosed, boosting the CEO’s reputation. Thus, they may be important even if the CEO holds significant equity.

One other reason for variable pay supported by both directors and investors is for the CEO to share external risks with investors and stakeholders. This is surprising and contradicts standard theories, since it implies inefficient risk-sharing. It is, however, consistent with a fairness model in which directors and investors also evaluate CEO pay relative to a set of reference points that includes shareholder returns.

Pay levels

Our third set of results concerns the level of pay. We first ask what determines the pay of a new CEO. Both directors and investors view CEO ability as most important. Unexpectedly, pay at peer firms is seen as more important than the new CEO’s actual outside options, such as pay at her prior firm and at other firms she could move to. One explanation is that peer compensation matters not only because it determines the CEO’s alternatives, but because it is a reference point she uses to assess whether her pay is fair.

When asked about increases in expected pay for incumbent CEOs, both directors and investors state that the primary justification is good recent performance. This is surprising given the substantial equity holdings that CEOs have, but is consistent with changes in flow pay providing ex-post recognition. Other justifications receive only minor support.

Directors and investors disagree on whether current pay levels are appropriate. 77% of investors view CEO pay as too high, and many believe that large cuts would have no adverse consequences. Most directors disagree, claiming that large cuts would force them to recruit lower quality CEOs and adversely affect CEO motivation.

In sum, we have identified interesting directions for future academic research by uncovering important determinants of CEO pay, such as fairness, that have hitherto been overlooked. Our results may also help practitioners by highlighting differences of opinion between directors and investors that cause conflicts about pay packages. Investor engagement often focuses on details of the contract itself, but initiating dialogues on these deeper disagreements may ultimately lead to more fruitful conversations on executive pay.

The complete paper is available for download here.

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One Comment

  1. Memory Nguwi
    Posted Wednesday, July 21, 2021 at 1:51 pm | Permalink

    These are interesting findings. My view is that a significant number of board members are captured by the CEO thereby impacting their objectivity when it comes to decisions that affect the CEO. It would be important to replicate these studies in other regions like Africa where director independence is a big challenge.