A leading governance scholar specialising in executive pay has scorned an emerging mood shift towards higher, US-style CEO pay deals for UK executives, after warning it is being spurred by magical thinking.

London School of Economics Emeritus Professor of Management Practice Alexander Pepper 

warns that calls for US-style CEO pay in the UK overlooks stark differences between the two nations’ economies.

New Deloitte research published this month found that more companies in the FTSE 100 aim to “significantly” boost executive pay and fast-track reviews, to compete with their US peers. According to Deloitte, of the 55 FTSE 100 firms that have so far published their annual reports for 2024, 24 are seeking shareholder approval for new pay policies. That’s compared to 16 by this time last year.

The story follows the theme of a previous FT report of 25 February, citing a change in tone among investors around giving CEOs of UK-listed firms pay deals to rival those of top US bosses. Indeed, since the beginning of the year news has emerged of efforts to award significant pay increases to CEOs at HSBC, Barclays, NatWest and BAE Systems.

In January, billionaire financier and ICAP Founder Lord Michael Spencer told the FT that London-listed firms should pay their CEOs like elite football players. “The US celebrates the fact that great chief executives earn large amounts of money,” he said. “They want their chief executives to be paid like football stars.”

Cause and effect

Pepper believes that the relative size of the US economy goes a long way to explaining larger CEO pay awards. “At more than $25tn, the size of the US economy is six times larger than the UK’s. Plus, at 333m, the population of the US is nearly five times greater than the UK’s 67m.”

On that basis, Pepper notes, it is “hardly surprising” that S&P 500 companies are much larger than FTSE 100 firms, with average market caps of $64bn and $23bn respectively. Therefore, top US firms are able to pay more on average – $14.2m in 2022, compared with the FTSE 100’s $5.3m. “If we look at the world’s 100 largest companies in 2023, 57 were based in the US,” he says. “Only five had primary listings on the London Stock Exchange.”

Pepper says two academic theories have sprung up to explain the sharp rise in executive compensation over the past 40 years.

Optimal contracting argues that large corporates must attract top management talent because they are far more complex to run than smaller companies. It also contends that CEOs’ decisions have a multiplier effect on firm-value growth because their actions are scalable. So on both grounds, big pay awards are essential.

Another theory, the market failure approach, argues that in the absence of accurate price signals, top executives can extract ‘rents’ above amounts deemed economically or socially necessary. This depends upon efficient markets, with many buyers and sellers, free entry and exit, plentiful data and little economic friction. “The trouble with the market for top executives is that it meets practically none of those conditions – hence, pay inflation,” Pepper says.

Across both theories, higher-pay proponents claim that if UK companies hired more talented CEOs by giving them larger deals, a greater number of UK firms would grow to be as big and successful as those in the US.

But, Pepper says, “This is magical thinking that confuses cause and effect. Around 80% of US CEO pay is provided in the form of equity. The incentive effect of that comes from aligning the possibility of significant compensation growth with the prospect of future growth in firm value. High equity-based pay should be an outcome – not an input.”

A finite pool

ICAEW Director, Corporate Governance and Stewardship, Peter van Veen agrees with Pepper’s stance. “It’s certainly the case that the reverse is true,” he says. “If you underpay to the point where you’re not attracting top talent and try to make do with people who aren’t up to the job, you’ll sink the business. 

“You could offer, say, £250,000 to £300,000 for the top role at a FTSE 100 company – but it’s pot luck. Whoever takes on the role may well be competent. But they will not be proven. Investors may also need some convincing that an untested CEO is the right choice.”

However, that only holds true up to a point, van Veen adds: “Once you go above a certain level, you’ll attract no better talent than you would for a lower number. That’s because the pool you’re fishing in is finite. No matter how much money you throw at it, you’ll never get Mark Zuckerberg to leave his role at Meta so he can come and run Thames Water. It’s just not going to happen.”

From an accounting perspective, the watchword must be prudence. The board has a fiduciary duty to look after shareholders’ interests and ensure that remuneration decisions are backed by careful considerations to avoid overspending. After all, it is not the board’s money, but that of the company’s investors. “Writing a blank cheque in the hope that a white knight will turn up and solve all your problems is irresponsible,” van Veen says.

As for Lord Spencer’s footballer-style pay plea, van Veen argues that comparing CEOs to strikers is the wrong analogy. “If you’re a CEO, you’re not a star football player. You’re the club boss. All your stars – dealmakers, engineers, project delivery specialists – are inside the business. That’s your squad. They’re the people who are scoring goals for you. 

“The correct analogy is that you’re CEO of Man City. Besides ensuring there’s sufficient money for transfers and salaries, your role is to make sure that tea bags are in the canteen, the stadium lights work and the kit’s paid for so your coaching staff and star players can go out and do their best.

“You’re not Pep Guardiola – and you’re certainly not Erling Haaland.”