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Study: Flawed Reasoning, Plus Prisoner's Dilemma, Responsible for Inflated CEO Pay

By:
Chris Gaetano
Published Date:
Jan 10, 2019
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A study from the London School of Economics has found that CEO pay is higher than it should be, and this is largely because of antiquated notions by boards about the relationship between pay and performance, but even if boards were willing to update their understanding, there's still an incentive to set compensation high to prevent other companies from poaching their chief executives, according to Forbes

The study's author, Alexander Pepper, said that most corporate compensation structures are developed with an idea that there is a direct relationship between high pay and high performance; a higher pay will attract a higher-quality candidate who will produce higher returns. However, he said that his own research has found that matters are not so simple. For one, he said, executives would prefer to have clear pay structures rather than  complex and ambiguous structures with potentially larger pay-offs. Also, such beliefs discount the importance of intrinsic motivation, such as personal fulfillment in a particular role. The research also found that executives generally discount the value of long-term reward schemes and deferred bonuses by 30 percent per year, meaning that they need increasingly large compensation packages in the interim to remain satisfied. Finally, they are also motivated by peer comparisons. 

It is this last point that might also be a factor in another major reason for ballooning CEO pay—industry norms. Boards would all like to pay their CEOs less, but unless every company in the same sector does so at once, anyone paying less will be penalized as the other companies that did not do so gain the reward of a deeper talent pool. This is basically the prisoner's dilemma, a situation where everyone gains the most by cooperating, but cannot necessarily trust the other parties to do so, and so everyone loses out on the optimal outcome.