Setting CEO pay

Researching the challenges of CEO compensation

CEO pay is a hugely important and often controversial subject, with many factors influencing and constraining compensation packages. Professor Dirk Jenter of the LSE Department of Finance is exploring new ways to investigate a subject that has a real impact on the success and public perception of businesses.

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WATCH: setting CEO pay with Dirk Jenter, LSE

CEO pay is crucial in attracting, retaining and motivating a CEO, but it also has implications for the company more broadly

The size and the design of the CEO pay package are important decisions for any company. CEO pay is crucial in attracting, retaining and motivating a CEO, but CEO pay also has implications for the company more broadly. Excessive CEO pay can demotivate employees, or it might cause a backlash from customers or other outside parties. Even more broadly, high executive pay makes headlines and affects how the public perceives the fairness of capitalism. Because of its importance, we want to better understand how CEO pay is set. This is where our research project comes in.

I have been conducting research on executive pay for more than 20 years. The standard approach for academic research in this area is for theorists to write down a model, and for empiricists like me to take these models to the data and test their validity. We have learned a lot from this approach, but it has its limitations. For example, while we can observe pay packages, we cannot observe the mental models and the goals of those setting CEO pay. What makes this project exciting is that we get to hear directly from the most important decision makers who determine CEO pay.

My coauthors (Alex Edmans and Tom Gosling from London Business School) and I have conducted a practitioner survey of the two most important players in the CEO pay setting process: directors on company boards and institutional investors. Directors are the most important actors because the board, through its remuneration committee and supported by pay consultants, determines the pay package. Institutional shareholders also have a lot of influence, because they get to vote on CEO pay, and it is the interaction of boards with institutional shareholders that shapes pay.

We were able to survey more than 200 directors of publicly traded UK companies and more than 150 representatives of institutional investors in UK equities. What is unusual about this survey is that we asked almost exactly the same questions to two different groups of decision makers, which reveals whether the two are aligned or whether they disagree.

Directors and institutional shareholders disagree about the most important goal in setting CEO pay

The survey responses revealed many interesting results that challenge our thinking about CEO pay. The survey’s first question asked respondents to rank the importance of three goals in setting CEO pay: attracting and retaining the right CEO; motivating the CEO; or minimizing the level of CEO pay. There was broad agreement between directors and shareholders that minimizing the level of CEO pay is least important. This is interesting, and it is a partial answer for why CEO pay is so high – none of the important players in the pay setting process view high pay as a first order problem. This does not necessarily mean that they view high levels of pay as justified, and there is other evidence in the survey that shareholders view CEO pay as too high. However, they do not view it as a first order concern.

Directors and institutional shareholders disagree about the most important goal in setting CEO pay. Most directors believe that attracting and retaining the right CEO is the main goal. Shareholders, in contrast, believe that motivating the CEO is more important. This disagreement reflects a theme that recurs throughout the survey. Investors are more focused on motivating and incentivising the CEO. Directors, on the other hand, worry more about the market for managerial talent and about the difficulty of finding, retaining and keeping happy that one good CEO they need.

The survey also revealed that boards feel incredibly constrained by the need to avoid conflict with various parties, such as employees, customers, or proxy advisors, when setting CEO pay. Two thirds of directors admit that they are willing to sacrifice shareholder value to avoid controversy on CEO pay. Hence, they are not simply setting CEO pay to maximize shareholder value, but setting it subject to the constraint of not getting into trouble with anyone they care about. The toughest constraint they are reporting is the need to obtain shareholder approval, that is, the need to avoid controversy with shareholders. This is surprising: if boards set CEO pay to maximize shareholder value, shareholder approval should be automatic. However, many directors do not believe that this is the case. Instead, they are convinced that shareholder interference in the pay setting process reduces shareholder value. Directors expressed a lot of frustration in both the survey and in post-survey interviews about institutional shareholders not fully appreciating the difficulty of finding, retaining and motivating CEOs.

neither directors nor shareholders view financial incentives as the most important motivator

Another interesting set of questions focused on the role of financial incentives in motivating CEOs. The most noteworthy result was that neither directors nor shareholders view financial incentives as the most important motivator. Instead, intrinsic motivation and the CEO’s personal reputation are seen by almost everyone as the most important drivers of CEOs. This is reassuring – most practitioners do not believe that CEOs are simply coin operated automatons that would not function without financial incentives. At the same time, however, practitioners, and especially directors, do believe that both the level of CEO pay and financial incentives are important in motivating CEOs – but it has to do with a specific notion of fairness.

Directors are concerned about the CEO’s perception of fairness, which is different from how fairness is typically discussed in the context of CEO pay. Many directors have a model of the world in which the CEO assesses the fairness of her pay by benchmarking it against what the CEO believes she deserves. If pay falls short of this benchmark, the CEO’s intrinsic motivation is undermined and her relationship with the board suffers. This is something that many board members worry about, and it explains their decisions around CEO pay.

This suggests a need for better communication between boards and shareholders

The results from our survey have opened up a range of new research directions. On the theoretical side, we have learned that CEOs’ concerns about the fairness of their pay package are seen as crucial by those setting pay. Theorists, including my coauthor Alex Edmans, are already working on models of CEO pay that incorporate this insight. On the empirical side, we need to better understand what benchmarks CEOs are using to assess the fairness of their pay. The survey suggests that the pay of peer CEOs, recent firm performance, and the CEO’s own prior pay affect what CEOs believe they deserve, but a lot more work remains to be done.

A hopefully useful finding for practitioners is that there is genuine disagreement between directors and institutional investors about both the primary goal of setting CEO pay and about the challenges faced by boards. This suggests a need for better communication between boards and shareholders and for an open discussion about shareholders’ role in the pay setting process. With most directors agreeing that long-term shareholder value maximization is the goal, it should be possible to reach a consensus on what optimal CEO pay looks like.

Dirk Jenter is Professor of Finance at the London School of Economics and Political Science.

Read more about his work at