How peer groups comparisons affect executive compensation

Research by Michael Faulkender

In 1980, the average CEO’s compensation was about 42 times what the average worker was paid. By 2007, CEOs received about 344 times the average worker salary. Some view the ballooning of executive compensation as a failure of corporate governance, or evidence of abuse of power. Others argue that it just reflects market forces: top CEOs must be paid top dollar, or they’ll take their (presumably irreplaceable) talents to other organizations.

But how do companies arrive at these astronomical sums? The compensation committee of the firm’s board of directors reviews and amends the recommendation of the firm’s human resources department, frequently working with outside compensation consultants. The compensation committee also benchmarks its firm’s pay packages against other companies with whom the firm competes for talent.

Michael Faulkender, assistant professor of finance, with co-author Jun Yang, Indiana University, believes that the choice of a peer group for benchmarking by a firm’s compensation committee has a strong influence on the size of the compensation package a CEO eventually receives.

“The reason executive compensation is an interesting marketplace to analyze is because CEOs have an influence on the compensation practices of the firm that other top talent do not,” says Faulkender. “When Katie Couric was hired by CBS, it was an arms-length transaction; she had no control over what management offered her as a pay package. But the same does not always hold true for CEOs. CEOs are involved with who sits on their board of directors. There is concern that those kinds of influences skew the results of executive compensation.”

In 2006 the Securities and Exchange Commission (SEC) required companies to disclose the companies which comprised compensation peer groups, enabling researchers to more closely examine the mechanisms by which executive compensation is determined. Faulkender collected the list of compensation peer companies used by S&P 500 firms and S&P MidCap 400 firms in the first fiscal year following the compliance date for the new rule for this study, the first of its kind. Salary, salary and bonuses, and total direct compensation were the measured separately.

Compensation committees, as might be expected, chose compensation peer groups from firms that were similar in size, industry, visibility, and had similar CEO responsibility. After controlling for these factors, the authors found that of two potential peers, both similar in size and in the same industry, the compensation committee and compensation consultant picked for its benchmarking group the peer company whose CEO received a bigger compensation package.

The choice of peer group may serve as a justification for high pay packages, because it reflects what a comparable level of skill and talent goes for in the marketplace. Seeing other similarly-paid CEOs helps make the compensation committee make the case for higher pay to the board of directors.

This effect is stronger in firms where the CEO is chairman of the firm’s board of directors, where the CEO has long tenure and where directors are busier serving on multiple boards. CEOs who have been with the firm a long time and serve as chairman of the board might be expected to have played a role in the formation and composition of the board, and thus have more power and influence over his or her own compensation committee.

Choice of peer group may also serve as an opportunity for gaming—for CEOs to influence their own compensation packages. “We do find evidence of gaming, but it could be much more egregious,” says Faulkender. Compensation committees choose compensation peer groups that have highly paid management. But they also appear to be comparing their own firms to firms of similar size—meaning they’re careful to compare apples to apples when it comes to the size and prominence of the companies they identify as peers.

What is the role of policy makers, regulators and outside investors in mitigating the effect of undue influence on executive compensation? Policy-makers can look at the structure of pay packages, says Faulkender, focusing attention on constructing incentives that better align the incentives of management with the success of the firm.

“Inside the Black Box: The Role and Composition of Compensation Peer Groups,” is forthcoming from the Journal of Financial Economics. For more information about this research, contact mfaulken@rhsmith.umd.edu.