In 1965, the CEO-to-employee compensation ratio at US companies was 20:1 – for every $1 earned by the average employee at a company, the chief executive at that company made $20. By 2021, the ratio was 399:1.
Although the pay disparity at UK companies is not quite as stark, recent figures show that not only is median executive pay at FTSE 100 companies more than 100 times that of the median full-time worker’s pay (109-times greater, in fact), but CEO pay is also rising faster than the average worker’s pay. CEO pay at FTSE companies increased by 16% in 2023. Meanwhile, according to the Office for Budget Responsibility, real wages for average full-time employees will not return to their 2008 value until 2028.
Statistics like these lead many people to question whether it’s fair for chief executives to receive such generous pay packages. However, others believe that while executive pay may seem exorbitant, remuneration based on market rates is the only way for firms to attract the very best leaders and remain competitive.
If executive pay does not follow the market rate, firms will be unable to attract the best leaders
Limiting executive pay puts companies at a great disadvantage and the current situation in the UK illustrates this point perfectly.
In most cases, chief executives at UK plcs are paid well below the global market rate – that is, the compensation levels at companies in the US and elsewhere. This risks a CEO talent drain, where the best leaders will naturally choose to work at US firms or UK companies in the private equity market, where there are no restrictions around remuneration.
We’re already seeing multinationals relocate their headquarters from London to the US, and we know that boards are worried about selecting chief executives from a less competitive talent pool.
Other factors compound this issue. Time spent on corporate governance in plcs has doubled, with CEOs often spending two out of every five days managing regulation and external stakeholders. In effect, executives are spending half as much time on the part of the job that they enjoy – leading the business – for half as much money as they could earn elsewhere.
Boards are worried about selecting chief executives from a less competitive talent pool
In this environment, we’re seeing CEOs actively look for roles in private equity-backed companies, where there is less regulation and the company can pay what they want.
Remuneration rules at UK plcs also create inflexibility in hiring. For instance, first-time CEOs are often happy to take a more modest remuneration package for the first year, with the agreement that the package will increase to the market rate once they have “proven themselves”. However, CEO pay increases at UK plcs are limited to the average employee pay rise, which prevents this test-period approach. Boards must therefore choose between defaulting to a ‘tried-and-tested’ CEO, or take a chance on a first-timer by offering higher pay rates from the outset.
Practicalities aside, market rates are also a natural and fair way to determine compensation. Consider, for instance, how market rates work in a different context. Few people complain that Marcus Rashford earns £350,000 a week, but it’s considered outrageous for a CEO to earn £3m a year.
Linking pay and performance is difficult and benchmarking by nature causes pay to spiral
Executive pay at FTSE 100 companies is typically 100- to 150-times higher than the average full-time salary for employees at those companies. The disparity is even greater at companies in the S&P 500. To many, this simply feels excessive.
The remit of the chief executive has expanded quite dramatically over recent years, with increased pressures around ESG, diversity and inclusion and broader stakeholder management. Perhaps relatedly, the average tenure for CEOs has fallen from seven years to less than four years. However, given the absolute level of executive compensation, it is likely that people will remain deeply sceptical about remuneration at the highest level of the compensation ladder.
When CEOs can influence the composition of the remuneration committee, it reduces the willingness of NEDs to challenge pay
Ideally, executive pay would be linked to performance. Although this is simple in theory, it has proved difficult to implement in practice. There is complexity in defining ‘performance’. How much of it should be value based? How much should be linked to non-financial performance? The metrics are also debatable. Should compensation be linked to total shareholder return (TSR), operating profit, economic profit, another metric linked to climate, or a combination of these? And, what about the peer set being used for comparison? Should it be industry specific, geography specific, or focus on companies above a certain size? Where should the threshold be set?
If you believe, as many do, that compensation should be largely linked to relative TSR, then according to research by Marakon it appears that there is a disconnect of up to $2m between how much executives should be paid and how much they are paid. And, this cuts both ways; by this measure, some CEOs are paid too much, while others are actually paid too little.
Businesses are starting to adopt better schemes for executive pay, with value-based incentives that promote good growth and compensation increasingly linked to group strategic priorities – but there is still a long way to go.
Flawed governance processes are often a factor in explaining deficient executive-compensation practices, particularly in North America. When CEOs can influence the composition of the remuneration committee, it reduces the incentive and willingness of non-executive directors to challenge pay. Another issue is the widespread use of compensation consultants, whose benchmarking against “peers” leads to an ever-increasing spiral of ‘median or greater’ pay awards. While the argument that we need to offer top pay to attract top talent has some merit, by its nature benchmarking creates a cycle that is hard to break.
To avoid these common pitfalls, it is important that the conversation around compensation is treated like any other investment. It is just that – an investment, with a cost, on which the company must generate a return.
