The real deal on CEO pay

The pay of top executives rises when their company does well and falls when their company does badly, according to academic research, which challenges the suspicion that executive pay rises inexorably regardless of corporate performance.

The research by two academics at the London School of Economics, based on a database of pay at 400 companies that represent 90 per cent of the UK's stock market capitalisation, suggests there is a strong link between top pay and performance. However, the study did find that executive pay appeared to fall more slowly in bad times than it rose in good times.

This is the first time that data covering everyone from the CEO to a cleaner in a large sample of firms have been collected in the UK. It allows for a rigorous exploration of how pay across a company changes as the performance of the company varies.

The research finds that:

- There are big differences in average pay – CEOs earn around 40 times more than the average worker, but this multiple rises to around 80 looking only at the very top companies comprising the FTSE 100;

- The majority of pay for CEOs comes from bonuses and stock incentive plans, whereas 95 per cent of workers' pay comes from basic salary;

- When firm performance improves, so does pay, but it goes up much more for CEOs than for ordinary workers. If the firm's value increases by 10 per cent, CEOs on average get an extra 3 per cent in pay, while workers get only 0.2 per cent more.

This close pay-for-performance link among CEOs is a recent development, driven by growth in bonuses and incentive packages – evidence from the 1980s and early 1990s found almost no link between pay and performance for executives.

In an 'aha!' conclusion that states the obvious that always seems to elude media commentators, the research confirms that base salary tends to be unresponsive to firm performance, while cash bonuses are very responsive.

Interestingly, the bonus elasticity with respect to performance is strongly positive for all workers, though again larger in magnitude for the more senior members of the hierarchy. So workers do see the fruits of success in their bonus payments. But this effect is not large enough to feed through to a significant effect on total pay since the bonus share of pay is only 5 per cent.

But the system as regards CEO pay still needs some work. The research indicates that CEO pay falls when performance falls, but this effect looks weaker than the upside, so there is some evidence of asymmetric pay-performance relationships.

Given that much of the debate focuses on inequality in pay outcomes, why do workers not enjoy the same rewards? The authors suggest that this may be the optimal result of an implicit insurance contract between workers and firms, with firms protecting workers from idiosyncratic shocks to the firm. That is, performance can go down as well as up.

Alternatively, it may be that an increasingly weakened workforce finds it harder to successfully bargain over rents. This latter explanation is consistent with the research's findings for the declining value of the pay- performance elasticity over time.

Guerdon Associates is an independent consulting firm operating from Sydney and Melbourne that provides advice on executive and director remuneration, performance management, governance, and employee equity data and solutions.