What determines CEO pay? Researchers typically answer this question by building models and testing their predictions with data. We’ve learned a substantial amount from this research—some of which has won Nobel prizes.

But these methods have limitations. Just like a flight or city simulator, a model needs to make assumptions—but how close are they to the real world? And the problem with data is that many key variables, such as a CEO’s intrinsic motivation, are hard to measure.

In a new paper, CEO Compensation: Evidence from the Field, we take a different approach—we survey over 200 UK directors and over 150 investors on how they design pay. The problem with any survey, particularly on a controversial topic like CEO pay, is that responses may not be truthful. So we used established academic techniques and extensive beta-testing to minimise this risk.

I teamed up with Tom Gosling, an LBS executive fellow and former head of PwC’s executive pay practice, and Dirk Jenter, a finance professor at LSE, to ensure the survey was both academically rigorous and practically relevant.

Intrinsic motivation

We first asked about respondents’ goals when setting CEO pay. The responses showed that 65% of directors view attracting the right CEO as most important, while 34% prioritise designing a structure that motivates the CEO. For investors, these figures are 44% and 51%.

This reflects a theme that recurs throughout our CEO pay survey: directors view the CEO labour market as much tighter than investors; shareholders wish to offer the “ideal” contract but directors are concerned it would drive some CEOs away. Only 1% of directors and 5% of investors prioritise keeping the level of pay down. CEO pay is a small percentage of firm value, while hiring a subpar CEO or providing suboptimal incentives has potentially large effects.

A total of 67% of directors admit that they would sacrifice shareholder value to avoid controversy on CEO pay. Surprisingly, the main source of controversy is investors (not employees or the public), even though investor support should be automatic if boards are setting pay optimally.

Instead, directors believe that shareholder guidelines, paradoxically, harm shareholder value. As one wrote, “shareholders appoint RemCos and then often seek to micromanage their duties.” A total of 77% report that investor pressure has forced them to offer less pay than they thought was optimal.

This disagreement could arise either because directors underestimate their ability to lower pay, or investors overestimate it. To disentangle these interpretations, we ask the 77% of directors who were forced to offer lower pay about the consequences. While 7% report that the CEO left, and 13% that they hired a less expensive CEO, 41% admit that there were no adverse effects—so they underestimated their ability to lower pay. However, 42% reported that the CEO was less motivated.

This result is interesting, because we typically view incentives as arising from how pay varies with performance rather than the level of pay. These results are instead consistent with a “fairness” model. CEOs are driven by intrinsic motivation, rather than because they need money to finance consumption. But if pay falls below what the CEO views as fair, her intrinsic motivation may be eroded.

Financial incentives

The importance of fairness comes up in our second set of questions, on the role of financial incentives in motivating CEOs. Both boards and shareholders believe they are relevant but secondary compared to intrinsic motivation.

However, financial incentives still matter, because they reinforce intrinsic motivation—in contrast to common claims that they crowd it out. CEOs believe it is fair to be rewarded for good performance; perceived unfairness would erode their intrinsic motivation. As one director stressed, “the retrospective acknowledgement of exceptional performance is important.”

Our third set of results concerns the level of pay. They showed 77% of investors view CEO pay as too high, and only 32% thought there would be adverse consequences if pay were cut by one-third.

Many claimed that any CEO who leaves is probably not the right person to begin with. Directors strongly disagreed, suggesting such a cut would demotivate even an intrinsically motivated CEO. However, they were more open to market-wide pay cuts, suggesting that Covid might be an opportunity to reset the level of CEO pay. Boards and investors might wish to take this opportunity and ensure that pay does not bounce back after the pandemic is over.

Long term vs short term

While our survey identified many differences of opinion, it also highlighted more consensus on some aspects than otherwise thought. Many directors were opposed to making incentives more long term, arguing that investors are focused on short-term returns—but 77% of investors supported such a move.

Directors claimed that investor guidelines force them into more one-size-fits-all pay structures, but investors reported that they would like more tailoring. There is support from both investors and some directors for paying the CEO like a long-term owner, with restricted shares rather than bonuses and LTIPs.

Pay disputes often focus on the contract itself. Our survey highlights the underlying differences of opinion that may be the root cause of disagreements on pay packages—and also areas of agreement. We hope that our results will help boards and investors understand the “other side”, thus paving the way for more fruitful dialogues on executive pay.

Alex Edmans is professor of finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit.