Why are company bosses paid so much?

Every year, large sums of money are paid to the leaders of the UK’s biggest companies. Some commentators describe these pay packages as being exorbitant, while others believe that today’s levels of executive remuneration are fit-for-purpose or should be even higher.

The average pay received by chief executive officers (CEOs) in the UK in 2023 was roughly £900,000 a year, according to the BoardEx database. The 25 highest paid CEOs in the country receive over £2.5 million each year.

CEO pay has increased substantially over the last two decades, reaching its height just before the global financial crisis of 2007-09. It has since stabilised at around 150% of the executive compensation awarded in 2000 (see Figure 1).

Figure 1: Change in real CEO compensation in UK firms (public and private), 2000-23

Source: BoardEx database

What’s more, growing numbers of UK boards are increasing the payments to their executives to maintain their companies’ competitiveness, as reported in a recent Financial Times article. These increases are not merely a reflection of individual performance, but also a strategic move to attract and retain top leadership talent amid international competition.

But rising executive pay is not without its controversies. Since 2002, in FTSE 100 companies (the largest exchange-listed firms in the UK), the UK salary gap – the ratio between the CEO’s pay and the pay received by the median worker in a company – has widened by more than 60% (see Figure 2). This illustrates a clear and concerning trend in income disparity.

Figure 2: Median salary gap in FTSE 100 companies, 2002-24

Source: S&P Capital IQ

The growing divide has prompted politicians, commentators and the general public to raise critical questions about the fairness and long-term sustainability of such pay structures, particularly against the backdrop of broader economic conditions that have generally not favoured the average worker.

To understand why CEOs are paid so much, one needs to understand how we got here and what determines CEO compensation.

How has executive pay evolved?

In the late 1970s, a significant shift in economic thinking emphasised maximising shareholder value, and the compensation paid to CEOs became closely linked to the performance of their companies.

This means that firms started to focus almost exclusively on maximising profits, such that shareholders (the owners of firms) benefited more by collecting higher annual (dividend) payouts or from greater share price appreciation. CEOs in turn were compensated for the profit they made for their shareholders.

This approach was initially introduced to reduce the potential conflict of interests between shareholders and company managers by aligning their goals (Jensen and Meckling, 1976). For example, a conflict of interest might occur if a CEO were to resist a merger or acquisition to protect their job, even if shareholders would benefit from the transaction.

Over time, this led to the rise of performance-based pay structures, which included shares and stock options that allowed CEOs to buy shares at a pre-set price.

In the 1970s, stock options and shares made up only a small part of CEOs’ total pay in the United States. But by the late 1990s, these elements dominated compensation packages, significantly boosting CEO earnings (Conyon et al, 2011).

The trend was similar in the UK, with the proportion of stock options in CEO pay packages growing from 3% in 1981 to 39% by 1989 (Main et al, 1996).

Since the mid-2000s, restricted stock awards – which come with a clause that prohibits a CEO from selling their shares for a certain amount of time together with performance conditions – have become increasingly popular. They are viewed as a more effective way to align CEOs’ interests with those of the shareholders.

This contrasts with stock options – which often reward immediate increases in a firm’s share price, giving executives the incentive to focus on short-term gains. Such schemes may encourage CEOs to pursue risky behaviours and short-term strategies (Economic Policy Institute, 2022).

CEO compensation is not just about salaries and stock options. It also includes substantial bonuses, severance packages and other perks that often do not depend on the individual’s performance.

For example, AstraZeneca’s CEO Pascal Soriot recently received a pay package of £18.7 million, which included significant bonuses, sparking a revolt among shareholders. Similarly, there was a notable case in 2023 where a £7.6 million payment to NatWest’s former CEO Alison Rose was cancelled, following a review of the bank’s decision to remove Nigel Farage, then leader of the Brexit party, as a customer.

Despite various controversies around boardroom payouts, spending on the use of company jets by CEOs – an example of the perks available – rose by 50% among S&P 500 companies (the 500 largest publicly traded companies in the United States) since before the Covid-19 pandemic, reaching a total expenditure of $65 million in 2022.

These developments highlight the continuing debate about the effectiveness of tying CEO pay closely to company performance. While the intention is to ensure that CEOs work in the best interests of the shareholders, the reality shows that compensation packages can become very generous and often seemingly disconnected from the company’s actual performance.

Today, when bonuses are paid, they make up between 24% and 52% of UK compensation packages. As shareholders and the general public grow more aware of these practices, it is likely that we will continue to see challenges and changes in how executive compensation is structured and justified.

Self-interest or good governance?

Some experts believe that CEO salaries are not tied closely enough to their performance because they have too much influence over the boards that set their pay. These boards might end up approving excessive salaries and benefits that do not necessarily align with the company’s success, which then hurts the shareholders (Bebchuk and Fried, 2004).

Efforts to control these high salaries through laws and regulations do not always work as intended. Changes in tax laws during the late 1970s and 1980s led to spikes in CEO salaries (Conyon and Singh, 1997).

Despite new rules in the early 1990s to make directors more independent, executives often still had a hand in setting their own pay. The UK tried to involve shareholders more by allowing them to vote on pay, but it is still unclear how effective this has been in aligning CEO and shareholder interests.

Further, economic changes in the UK during the 1980s weakened trade unions, which had previously helped to keep executive pay in check (Blanchflower and Freeman, 1993).

In the United States, similar issues have arisen. Attempts to regulate CEO pay through changes in tax, accounting and securities laws sometimes backfired, leading to even higher salaries as companies found loopholes.

In the 1990s, for example, stock options became a popular way to compensate executives, partly due to favourable tax and accounting treatments. But this led to scandals in the early 2000s, prompting new regulations that reduced the appeal of stock options (Shue and Townsend, 2017).

Despite this, new forms of compensation – like restricted stock awards – have been criticised for potentially rewarding poor performance (Wall Street Journal, 2003). These challenges highlight the complexity of regulating executive compensation.

What determines CEO pay?

Due to the complex nature of executive pay, understanding what determines it is important. Figure 3 shows that there is a positive correlation between CEO pay and the total returns (dividends and share price increases) that the firm provides to its shareholders.

Figure 3: Correlation between CEO pay and returns to shares in FTSE 100 firms, 2022-23 (corrected for outliers)

Source: Datastream and BoardEx database

Firms that prove to be a good investment reward their CEOs with higher pay. This relationship is consistent with the pay-for-performance hypothesis, which posits that executives are compensated based on their ability to enhance shareholder value. Executive compensation thus serves to align incentives and solve conflicts of interest.

Alternatively, managerialists argue that CEO compensation is largely determined by firm size.

In reality, there are many determinants that extend beyond mere shareholder returns. These include:

Corporate and industry characteristics: Industries with high volatility and competition may offer higher pay to attract and retain top talent (Murphy, 1999). Similarly, larger firms pay higher salaries due to the complexity of the business (Tosi et al, 2000).
Corporate governance: Boards with a higher proportion of independent directors are more likely to design compensation packages that align with shareholder interests, leading to lower levels of CEO compensation (Core et al, 1999). Similarly, when shareholders have more to say about how their CEO is compensated, firms tend to have lower CEO pay and more performance-linked compensation (Ferry and Maber, 2013).
Growth and benchmarking: CEOs who have successfully navigated their company through challenging times or significant growth phases are rewarded with higher pay (Gabaix and Landier, 2008). When CEO pay is based on the compensation levels at peer companies, it can lead to upward pressure (Bizjak et al, 2008).
Environmental, social, and governance (ESG) and corporate social responsibility (CSR) practices: CEOs may jeopardise personal wealth by pursuing stakeholder-related initiatives (Coombs and Gilley, 2005). That is, many socially responsible activities are often not captured in the CEO’s contract and they therefore have no financial incentive to pursue acts for the greater good. More and more, CEOs are now being given incentives to advance sustainable business practices as well as ensuring good financial performance (Flammer et al, 2019).
Personal characteristics: More extrovert or narcissistic CEOs tend to earn higher pay (O’Reilly et al, 2014; Malhotra et al, 2021), Women CEOs earned 6% higher compensation than their male counterparts in the United States from 1996 to 2005 (Hill et al, 2015); and CEOs perceived as more competent or attractive receive higher pay (Canace et al, 2020).

Striking the right balance

While CEO pay has risen over the last couple of years and the debate over whether this is justified has intensified, CEOs of large companies receive compensation for their talent in managing complex businesses.

Although investors only see a few adverse consequences of lowering CEO pay, directors, when asked, believe that lowering pay significantly would negatively affect the quality and motivation of the CEO (Edmans et al, 2023).

The rise in pay has sparked controversy due to the growing disparity with median employees’ salaries, raising questions about fairness and sustainability. Since the 1970s, economic policies, corporate governance and performance-based incentives have driven increases in CEO pay.

This rise stems from factors like firm size, industry dynamics and corporate governance, along with recent ESG trends and pandemic responses.

As such, the reasons why CEOs get paid so much are complex. Their pay structures, while aligning executive interests with shareholder value, need a balanced approach to ensure fairness, sustainability and business competitiveness.