Vlerick Business School has developed a “rich” database, fed every year with data on all aspects of CEO remuneration (for example, remuneration level, remuneration structures, typology of long-term incentives, and key performance indicators) in listed firms in the United Kingdom, Germany, France, the Netherlands, Belgium and Sweden.
In the last edition, we were especially interested to find out which strategies underly executive remuneration in the best-performing firms (with sustained performance being operationalised as a significantly higher return on assets over a seven-year timeframe, compared with companies in the same industry).
The results were surprising as well as promising. In general, we found that the best-performing firms paid their CEOs relatively less, ceteris paribus (other things being equal); they were relying less on variable pay (i.e., the proportion of variable pay was lower); and they were characterised by a smaller pay ratio (i.e., pay span between the CEO and the average employee).
Interestingly, we found no difference regarding long-term incentives. This means that better-performing firms do not make more (or less) use of long-term incentives such as performance shares, stock options, and so on.
Reward specialists told us that these results were not that easily predictable. In their minds, and taking into account their belief in the “power of rewards”, they thought there would be a positive correlation between CEO pay levels and the performance of their firms, and that better-performing firms would have a higher proportion of variable pay, because better results would lead to more pay.
So, the time has come to look for some explanations for our findings, and modesty seems to be the key word.
As far as long-term incentives are concerned, a number of authoritative academics from London Business School, such as Alex Edmans and Freek Vermeulen, have already taken a critical attitude towards the (behavioural) impact of performance shares and stock options.
In this respect, Alex Edmans pleads for a thorough simplification of share-based remuneration schemes, and even for replacing them by free share grants (not yearly granted!) to be held for long periods of time. This would encourage a long-term focus and is presumed to have a positive impact on sustainable shareholder value creation; or at least to align the interests of the CEO with those of the shareholders, for as long the latter have a perspective of share-holding rather than share-trading.
But, how to explain the finding that better-performing firms pay their CEOs relatively less? We see a double explanation: one from a psychological and one from an economic perspective.
As far as the economic perspective is concerned, it seems to be that better-performing firms make more efficient use of their (financial) means and are more savvy. Ultimately, this is also the case for executive remuneration—no exaggeration.
The psychological perspective deals with insights into the motivation of top executives. Our own research (of 950 CEOs in Belgium and the Netherlands) proved that the main factors driving CEO engagement include challenge, a feeling of having an impact and moving the organisation forward, and pride in working for the organisation.
In this list of main drivers of work engagement, we do not find any financials. It seems to be the case that better-performing firms and their boards are more aware of what really motivates top executives. But also, working for a well-performing firm is a motivating factor in itself (pride).
Having to pay high salaries in order to attract the best top executives is a popular mantra in board circles, but our research shows that this is a mistake. High salaries seem to be a compensation for a lack of other (and more effective) motivating factors.
Last, but not least, what about variable remuneration? Expectancy theory says that variable pay—that is, paying for performance—makes sense and might even be necessary. That is not the discussion at stake. What is much more important is the weight of variable pay in the total package. There needs to be a minimum in order to have an impact and to send a (hopefully positive) message.
But making the proportion of variable pay too high increases the risk of misreporting and even increasing stress levels. The best-performing firms reward their top executives for their performance, but they do not exaggerate. No over-incentivisation.
Xavier Baeten is professor of management practices at Vlerick Business School.