The Advisors' Blog

The capuchin monkey experiment is often trotted out as an example of how pay inequity demotivates employees. If we’re anything like the monkey in the experiment, we’re happy to be paid in cucumbers until we see that our colleague is getting delicious grapes. Well, directors are pretty convinced that CEOs have the same tendencies, according to a recent study from Alex Edmans and other business school profs.

In the UK-based survey of over 200 non-executive directors and 159 investors, people seemed to agree that an astronomical level of CEO pay isn’t important to execs because it “finances consumption,” but because it makes them feel like they’re being treated fairly in comparison to their counterparts. In other words, they want to feel special – which means making at least as much as their peers and getting recognized for accomplishments. In the absence of an across-the-board change (and/or a breakthrough in non-monetary ways to motivate execs), that makes it difficult to depart from the “tyranny of the 75th percentile” and ever-increasing peer-based pay – even though investors keep saying they won’t stand for it.

Here’s what else the study showed about pay decisions:

1. Directors and investors consider intrinsic motivation and personal reputation to be the most important sources of incentives for CEOs.

2. While the primary reason for variable pay is to motivate the CEO to improve long-term shareholder value, this is not because the CEO obtains utility from consuming the additional pay from good performance. Instead, variable pay provides ex post recognition of good performance, addressing the CEO’s fairness concerns and boosting her reputation.

3. How much the CEO can affect firm performance is the main determinant of pay variability. Directors view peer firm practice and investor or proxy advisor expectations as important constraints, hindering them from tailoring pay – even though investors themselves do not consider following peer practice as important. Firm risk and CEO risk aversion are not important determinants.

4. Investors strongly believe that lengthening the horizon of CEO incentives would improve decision making, with few adverse consequences. Directors disagree. Some directors are concerned about the attraction/retention effects of such a change; others believe that incentives would become less effective.

5. The majority of directors and, in particular, investors, believe that benchmarking of CEO performance measures should not be universal. One reason is that it is fair for CEO pay to mirror the shareholder experience. A second is that, for many companies, it is difficult to define an appropriate peer group or obtain information on peer performance.

– Liz Dunshee