When President Biden recently vetoed a bill that would have prohibited some retirement plans from weighing environmental, social and corporate governance factors when selecting investments, he cited “overpaying executives” as a concern that investment managers should be able to take into consideration. CEO pay is merely the latest point of contention in the political fight over ESG, but, like many things political, the arguments have become oversimplified. To properly investigate the topic, even proponents of ESG investing must ask: When we think about the fundamentals of good corporate governance, what does the evidence have to say about CEO pay? The results may be surprising – and serve to highlight why it’s important to pay attention to the nuance.
First and foremost, designing executive compensation in a way that aligns a CEO’s interest with those of shareholders is critical for good governance.
First and foremost, designing executive compensation in a way that aligns a CEO’s interest with those of shareholders is critical for good governance. It is important for not only attracting and retaining a talented CEO – what economists call the participation constraint – but also for motivating that CEO sufficiently to work hard and act in the interest of shareholders – the incentive constraint. The incentive element typically uses equity instruments to directly link executives’ payoffs to shareholder value. What an optimal incentive contract looks like, who ultimately determines the pay package and what outcomes incentive compensation schemes produce are all at the center of an intense debate among both academics and practitioners (the recent controversy around Elon Musk’s $50 billion pay package at Tesla serves as an excellent example).
One issue in ESG metrics is the question of what constitutes fair compensation for executives.1 The broadness of the issue, however – as well as the vastly differing conceptions of fairness that can arise in response – may complicate attempts to reach a consensus. Instead, it may be helpful to consider whether the large CEO pay packages that we observe are the optimal contracting outcome in a competitive labor market, or an indication that powerful and entrenched managers set their own pay with the help of boards that they effectively control.2
ESG advocates have embraced the pay ratio – the ratio of CEO pay to median worker pay – as a key metric in the name of good governance. The World Economic Forum suggests, for example, that all companies report it to show how stakeholder-friendly they are. Its supporters argue that companies that are “more equal” according to their pay ratio will have better and stronger cultures, which will lead them to stronger financial performance.
Unfortunately, research shows otherwise. A simple focus on pay ratio suggests that lower pay ratios should be intrinsically better than high ratios. However, the evidence is, in fact, high pay ratios are associated with higher long-term profitability and firm value.3 There are several potential reasons for this positive link. It might be that higher pay attracts and incentivizes the best managerial talent or that high pay is in fact due to strong long-term performance. The problem with using the pay ratio as a key metric is that it is largely uninformative. For example, the pay ratio will naturally vary across industries. Consider investment banks versus supermarkets; the pay ratio will be lower for the former than the latter simply because midlevel bankers are well paid, even if they are not executives. Similarly, high-growth firms will naturally have higher pay ratios than mature firms.4 Measuring pay ratios can also set up perverse incentives as CEOs can lower the ratio by outsourcing or automating low-paid jobs.
Ultimately, where the pay ratio fails as a “stakeholder metric” is because the logic is anchored in the mindset of splitting a fixed pie: If a CEO’s share of the pie is reduced, it means there will be more for the employees. What should be in the best interest of both shareholders and stakeholders, rather, is incentivizing the CEO to grow the pie in a way that can benefit all.
Thus, CEO pay should matter only to the extent to which it might damage employee morale and thus firm value, or if paying the CEO excessively directly costs shareholder value, rather than to show how stakeholder-friendly a company can be.
When workers feel they are not paid fairly, the firm may experience public backlash, resentment among its employees and difficulties in hiring.
CEO pay does matter when it affects worker morale. When workers feel they are not paid fairly, the firm may experience public backlash, resentment among its employees and difficulties in hiring. Moreover, surveys indicate that the majority of Americans are troubled by large pay gaps and believe firms have a responsibility to address income inequality by paying their workers a living wage.5 Therefore, firms need to address these concerns if they are to be competitive in attracting and retaining talent, which may include raising wages above the competitive rate set by the market.
While these higher wages will eat into a firm’s bottom line – potentially transferring wealth from shareholders to employees – the evidence again suggests that providing higher wages is not a zero-sum game. A large body of literature has explored a concept called “efficiency wages,” where higher wages lead to changes in employee productivity and these productivity gains can fully compensate shareholders for the higher wages.6 It is important to acknowledge, however, that any such raises by individual firms are unlikely to have significant impacts on national trends in income inequality. One firm acting alone is unlikely to move the needle.
What does research tell us about getting CEO compensation right for good governance? Quite a bit, but it comes down to a few fundamentals. First, the best way to align interests is simply by making sure that CEOs have skin in the game. An often-cited study of owner-CEOs – CEOs who are voluntarily heavily invested in their firm – finds that these firms deliver higher stock returns than those with low managerial ownership, and also have higher returns on assets, have a more productive workforce and are more cost-efficient.7 In other words, incentives work.
Second, giving CEOs a long horizon also matters. Incentives tied to short-term equity returns give rise to adverse outcomes – like slashing investment inefficiently to inflate earnings in an attempt to boost the near-term stock price around when they have more equity vesting.8 Requiring a long enough runway that sometimes even extends to after they leave their position can ensure that CEOs are not tempted to leave a mess for their successors.
Third, discrete performance targets can be counterproductive. For example, if hitting a target comes at the expense of cutting R&D for the firm, adverse long-term valuation effects can result that may not be immediately apparent to shareholders.9 Rather than tying compensation to specific metrics, firms that increase long-term incentives for executives improve not only long-term profitability and sales growth but also ratings for the environment, customers and communities.10 In the end, getting CEO compensation right for good governance in a way that benefits both shareholders and stakeholders simply requires linking it to long-term value.
This insight is a select portion of our larger report titled “Stakeholder Capitalism + ESG Investing.”
1 See, for example, MSCI ESG Ratings Methodology: Pay Key Issue
2 Bebchuk, L., & Fried, J. (2004). Pay without performance: The unfulfilled promise of executive compensation. Harvard University Press. https://doi.org/10.2307/j.ctv2jfvcp7; Faleye, O., Reis, E., & Venkateswaran, A. (2013). The determinants and effects of CEO–employee pay ratios. Journal of Banking & Finance, 37(8), 3258-3272. https://doi.org/10.1016/j.jbankfin.2013.03.003
3 Mueller, H. M., Ouimet, P. P., & Simintzi, E. (2017). Wage inequality and firm growth. The American Economic Review, 107(5), 379-383. https://doi.org/10.1257/aer.p20171014; Faleye, O., Reis, E., & Venkateswaran, A. (2013).
4 Frydman, C., & Papanikolaou, D. (2018). In search of ideas: Technological innovation and executive pay inequality. Journal of Financial Economics, 130(1), 1-24. https://doi.org/10.1016/j.jfineco.2018.06.014
5 Francis, T. (2022). CEO Pay Packages Rose to Median $14.7 Million in 2021, a New High. Wall Street Journal. https://www.wsj.com/articles/ceo-pay-packages-rose-to-median-14-7-million-in-2021-a-new-high-11652607000
6 For example, see Akerlof, G. A., & Yellen, J. L. (1990). The Fair Wage-Effort Hypothesis and Unemployment. Quarterly Journal of Economics, 105(2), 255–283. https://doi-org/10.2307/2937787
7 Lilienfeld-Toal, U. V., & Ruenzi, S. (2014). CEO ownership, stock market performance, and managerial discretion. The Journal of Finance, 69(3), 1013-1050. https://doi.org/10.1111/jofi.12139
8 Edmans, A., Fang, V. W., & Lewellen, K. A. (2017). Equity vesting and investment. The Review of Financial Studies, 30(7), 2229-2271. https://doi.org/10.1093/rfs/hhx018
9 Bennett, B., Bettis, J. C., Gopalan, R., & Milbourn, T. (2017). Compensation goals and firm performance. Journal of Financial Economics, 124(2), 307-330. https://doi.org/10.1016/j.jfineco.2017.01.010
10 Flammer, C., & Bansal, P. (2017). Does a long-term orientation create value? Evidence from a regression discontinuity. Strategic Management Journal, 38(9), 1827–1847. https://doi-org.10.1002/smj.2629