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CEO Pay and Compensation Boards

Most decisions about CEO pay are made by a compensation committee of a company's board of directors. Typically, says O'Reilly, the CEO hires a compensation consultant to determine what executives in the company "should" be paid and ma kea presentation to this committee, which almost always consists of company outsiders. Following the presentation, the committee asks the CEO to leave the room so it can come to a decision. Social forces in this room are what drive CEO pay, says O'Reilly. Assuming that economic factors like company size and profitability are constant, he found that social dynamics within the compensation committee—not the labor market—have a dramatic effect on CEO compensation.

First, says O'Reilly, there is a strong element of peer-group comparison in determining how much the CEO is paid. The chairman of the compensation committees typically the chief executive of another company, and his best gauge for what CEO ought to be paid is his own salary. "There's this natural anchoring effect," says O'Reilly. "The first number is set and you adjust off that."O'Reilly found that the more the chairman of the compensation committee was paid,the more the CEO could expect to make. Controlling for all other factors—company size, performance, CEO tenure—a CEO could get the same pay increase by doubling the company's return on equity from 15 to 30 percent—a Herculean feat—or by appointing someone to chair the compensation committee who made $100,000more in salary. Says O'Reilly, "I leave it to you which is easier to do."

A feeling of indebtedness to the CEO is also a strong determinant of high CEOpay. "There is a widespread norm of reciprocity across all societies," saysO'Reilly. In other words: you scratch my back and I'll scratch yours. The people sitting in the room deliberating over the CEO's pay package tend to feel obligated to the CEO, often, quite simply, because she gave them a plum position on the board. So they want to reciprocate by awarding her a good salary."Ostensibly, these compensation committee members are independent, but they are almost always appointed by the CEO," says O'Reilly. To support this theory,O'Reilly found that in cases where the chairman of the compensation committee was appointed before the CEO had joined the board—and had therefore never been subject to her approval—the salary approved for the CEO was roughly 12 percent less. In other words, committee members who owe their position to the CEO tend to be more generous with the CEO than committee members who do not feel indebted to her.

Finally, social status turned up as a factor. "People of higher social status generally get more," says O'Reilly. He went to Who's Who and the social register and, based on various factors, such as whether a person went to an elite university, devised an index of executives' social status. All other things being equal, he found that if the CEO was of higher status than the chairman of the compensation committee, he tended to get more money. Conversely, if the chairman of the compensation committee was of higher status, the CEO got less money.

"The economists' models are very elegant," says O'Reilly. "And they are abstractions. I didn't construct some abstract model at 30,000 feet; I looked at how decisions are actually made." But although he disagrees with "tournament theory" and other economic theories of executive compensation, the presence of leading economists at Stanford is important to O'Reilly. He believes it is the mingling of very different perspectives on executive pay—from the sociological to the economic—that is helping to bring the complicated issue into focus.

Related Information

The CEO, the Board of Directors and Executive Compensation: Economic and Psychological Perspectives, Industrial and Corporate Change, vol. 4, no. 2 (1995), pgs. 293-332