Overpaying CEOs, compared to their peers, may benefit shareholders

April 30, 2010

University Park, Pa. -- In the wake of the recent financial crisis, what many perceive as excessive executive salaries have grown as a target of popular outrage and Washington lawmakers. However, according to forthcoming research coauthored by a professor at the Penn State Smeal College of Business, overpaying CEOs as compared to their peers may actually benefit shareholders, while underpaying them could have negative consequences.

In a paper forthcoming in the Strategic Management Journal, Smeal's Vilmos Misangyi, assistant professor of management, and coauthors Eric Fong of the University of Alabama in Huntsville and Henry Tosi of the University of Florida examine the salaries of 800 CEOs in 30 industries over the course of 10 years. Instead of measuring executive compensation compared to firm performance, Misangyi and his colleagues measure CEO pay according to what other executives are making at similar firms and in similar industry conditions.

Their findings indicate that it may be better for shareholders to overpay their CEOs than to underpay them.

According to the research, CEOs who are overpaid compared to their peer CEOs paid closer to the market rate created a greater return on assets for their firms. Further, Misangyi and his colleagues find that comparatively underpaid CEOs tend to grow the size of their firms and are more likely to leave the firm, two outcomes that don't necessarily bode well for shareholders.

The pay deviations create dissonance in the executives and the researchers find that the CEOs take action to alleviate it. In the case of underpayment, the researchers find that CEOs have a choice between two courses of action: They can either leave the firm or try to increase their rewards.

"By growing the size of the firm, there's intrinsic, nonmonetary rewards in it for the CEO," Misangyi says. "CEOs tend to have high-power motivation as well as reasonably high levels of achievement motivation, so by growing their firm, while not necessarily a good thing for shareholders, they may reap more power, more prestige, and fulfill their achievement needs. While it may not seem like much, theory suggests that these intrinsic rewards alter the situation enough to change the CEO’s thoughts on fairness."

When CEOs are overpaid, there is again dissonance, but in this situation, the researchers find that the actions taken by CEOs to amend the situation are in a more beneficial manner to shareholders.

"If a CEO is overpaid, then he or she has two choices in order to justify fairness concerns: Ask for less pay or put forth more effort -- and prior research tends to support the latter," Misangyi said. "The wrinkle is that most CEOs' pay is performance based so if they increase their performance, then they get paid more. What we argue is that it still makes sense in terms of fairness concerns because, as an individual, if all I can do is increase my efforts toward getting the performance I am getting paid to produce, then I'm doing what I can do to reconcile these fairness concerns."

The bottom line, Misangyi said, is that underpaying a CEO has a negative effect for shareholders. However, he cautions that boards should not use this research to justify high CEO salaries. "If all firms start overpaying their CEOs, these relativity effects are still going to take hold, and CEO salaries will continue to skyrocket."

Their study, "The Effect of CEO Pay Deviations on CEO Withdrawal, Firm Size, and Firm Profits," is scheduled to be published in the June issue of Strategic Management Journal.

  • Vilmos Misangyi

    IMAGE: Penn State

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Last Updated July 28, 2017