Boards and investors disagree on CEO pay

New research reveals most directors will sacrifice shareholder value to avoid CEO pay controversy

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Whether it is anxiety about the economic fallout from the pandemic, or the ongoing national debate over fairness and equality, there remains an abiding focus on executive pay in the UK. Public disagreements on pay between companies and their investors continue to fuel such attention, which, in turn, has an influence on boards determining CEO pay.

New research finds that 67% of directors would sacrifice shareholder value to avoid controversy on CEO pay and 56% of investors would tolerate such a move. Surprisingly, directors view shareholders themselves (and their advisers, proxy agencies) as being the biggest impediment to setting pay to maximise shareholder value. Shareholder guidelines may, paradoxically, harm shareholder value by leading to lower levels of pay, and more one-size-fits-all structures, than boards would like.

More than 90% of directors and investors agree that intrinsic motivation and personal reputation are the most important sources of motivation for CEOs to perform strongly. But financial incentives still matter – they are viewed as important by 76% of directors and 68% of investors. However, the channel is quite different from standard theories, where financial incentives matter because CEOs will only exert effort to improve firm performance if they are compensated by the potential of additional consumption. Instead, CEOs are intrinsically motivated to create value, but also believe it is fair to be recognised for a job well done. The failure to do so erodes CEOs’ sense of worth and undermines their intrinsic motivation.

Investors believe incentives could be sharpened and more strongly aligned to shareholder interests, with 78% believing CEOs would make better decisions if pay was more long term. Only 21% of directors agree and instead believe that this change would have adverse consequences including blunting the effectiveness of incentives and making it harder to attract or retain the right CEO. By contrast, investors (79%) and boards (84%) agree that CEOs should share in risk alongside investors and stakeholders - even if these risks are outside the CEO’s control. For example, it is fair for CEO pay to fall in a pandemic, and rise in an economic upswing, even though neither are due to the CEO.

More than three quarters (77%) of investors think that pay is too high or far too high, with 86% agreeing that boards are ineffective at lowering it even though they should, and only 18% believe that a company would recruit a lower quality CEO if pay were cut by a third. By contrast, 59% of directors believe the company would recruit a lower quality CEO and only 10% believe there would be no adverse consequences.

These are some of the key findings of new research by Alex Edmans, Professor of Finance at London Business School, Dr Tom Gosling, Executive Fellow of the Centre for Corporate Governance at London Business School, and Dirk Jenter, Associate Professor of Economics at the London School of Economics.

The study, 'CEO Compensation: Evidence From the Field', surveyed more than 200 directors and 150 investors in FTSE-listed companies. It reveals the dynamics around remuneration of CEOs, including the objectives and constraints facing board directors and professional investors in devising executive pay, as well as the determinants that make up CEO remuneration.

Dr Gosling commented: “Key to the findings are the underlying differences in opinion between directors and investors and this may be a root cause for disagreements on pay packages. Investors typically focus on the detail in incentive plans, whereas boards are more focused on getting the right person, and, if they are good, keeping them through competitive pay awards and tailored remuneration packages.

“The fact that a significant majority of directors and investors would sacrifice shareholder value to avoid controversy on CEO pay shows that fears of adverse reputational consequences weigh heavily. But what’s surprising is that directors view shareholders as the main constraint that prevents them designing pay plans that maximise shareholder value.

“Investors think directors are weak on CEO pay, whereas directors think investors are ignorant of the realities of recruiting and motivating CEOs. With such a difference in world views, disagreements are inevitable. Each blames the others’ advisers [proxy agencies and remuneration consultants] for having too much influence. But to make progress we need more dialogue between boards and investors to improve mutual understanding of the challenges each face in setting CEO pay.”

Professor Edmans commented: “Our survey highlights the underlying differences of opinion that may be the root cause of disagreements on pay packages. Investor engagement often focuses on the aspects of the contract itself, but initiating dialogues on these deeper disagreements may ultimately lead to more fruitful conversations on executive pay – such as the depth of the CEO labour market and the drivers of CEO motivation.

“And there may be more consensus on some aspects than thought. Directors are concerned that investors prevent them from tailoring contracts and prefer short-term returns, yet many investors would like directors to tailor and make incentives more long-term. Both investors and some directors support paying the CEO like a long-term owner, i.e. with restricted shares rather than bonuses and long-term incentive plans. So our results point to potential paths forward.”

The full breakdown of responses together with mean responses and data on the number of responses can be found in the full paper. For further information, please refer to the 'CEO Compensation: Evidence From the Field' report for practitioners in business.