Research: Fairness Plays a Critical Role in CEO Compensation
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Boards should design compensation systems that reflect both performance and fairness. Transparent, threshold-based contracts can motivate CEOs while
reinforcing fairness throughout the organization. This approach aligns stakeholder interests and strengthens organizational cohesion.These are among the key findings of the study A Theory of Fair CEO Pay, by Pierre Chaigneau, Queen's University; European Corporate Governance Institute (ECGI); Alex Edmans, London Business School - Institute of Finance and Accounting, European Corporate Governance Institute (ECGI), and Centre for Economic Policy Research (CEPR); and Daniel Gottlieb, who as at the London School of Economics at the time and who is now at Hebrew University in Israel.
The authors assert that traditional models of executive compensation assume CEOs are motivated solely by consumption
—the benefits they get from spending their money. This paper introduces another powerful additional motivator: fairness. They contend CEOs care deeply about being fairly rewarded for their contributions, especially in relation to firm performance.The study is based on theoretical modeling with field evidence gathered through a large-scale survey and interviews with 203 non-executive directors of FTSE All-Share companies and 159 institutional investors in UK equities. Aspects of this study were first reported in 2021 in an article in the Harvard Law School Law School Forum for Corporate Governance. The survey conducted for the study found that:
- Fairness matters: Both directors and investors emphasized fairness over consumption as a key driver of CEO motivation.
- Real-world constraints: 67% of directors said they would sacrifice shareholder value to avoid controversy over CEO pay.
- Divergence in views: Directors and investors often disagree on what motivates CEOs and how pay should be structured.
Among the updated study’s findings.Fairness counts. CEOs feel dissatisfied when their pay falls below what they perceive as a fair share of the firm’s performance. This perception affects their motivation, even if they are already wealthy, the authors contend.
Performance-vesting contracts. The optimal contract includes a threshold-based structure:
- Zero pay for low output (to strongly incentivize performance).
- Fair wage for moderate output (to maintain fairness and motivation).
- Full output share for very high output (if fairness concerns are low).
Beyond incentives. Pay-for-performance isn’t just about inducing effort—it’s also about attracting and retaining CEOs who value fairness. This, the authors say, reframes compensation as a tool for alignment and engagement, not just motivation.
The paper does not specifically address employee pay. Are fairness concerns exclusive to CEO pay? Employees also compare their pay to performance, peers, and expectations. In either case, if pay is perceived as fair and performance-based, it can enhance trust in leadership; reinforce a culture of meritocracy, reduce resentment and disengagement, the authors say.
Conversely, perceived unfairness—especially if executives are rewarded for luck—can erode morale across the organization.
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