From the November/December 2012 issue of Treasury & Risk magazine

Pay Peer Groups Questioned

Using peer groups of similar companies to determine executive compensation can lead to pay inflation, a study charges.

How to determine executive compensation remains a hot issue, with a recent Institutional Shareholder Services survey showing executive pay is the top governance issue for institutional investors. Meanwhile, a research paper from the University of Delaware’s John L. Weinberg Center for Corporate Governance has focused debate on the standard practice of benchmarking CEO compensation by looking at a group of similar companies, which it argues leads to escalating pay levels. 

Charles Elson, chair of the Weinberg Center and co-author of the study, says selecting the companies to include in a peer group invites manipulation of the results, while the fact that compensation is typically set at the 50th, 70th or 90th percentile level found in the peer group “leads to a ratcheting up of all CEO salaries.”  

Most importantly, the basic premise—the notion CEOs can easily move from one company to a competitor—is not accurate, Elson argues. “There is really no external market for CEOs. The skills of a chief executive are company-specific, involving experience, the relationships with other managers and executives and the culture of the company, and the odds of a CEO leaving a company over compensation are slim to none.”

Elson and co-author Craig Ferrere, a fellow at the center, recommend boards look at internal factors to set executive pay.

Todd Lippincott, managing director for executive compensation in the Americas for Towers Watson, agrees that CEO skills are not readily transferrable and says this weakens the case for peer group benchmarking. But he argues that Elson and Ferrere overstate the extent to which corporate boards rely on such benchmarking. 

“We find that companies use peer groups as one data point—an important data point for sure, but not the only one,” he says. “In many cases they’ll use multiple peer groups—a narrow one of like-sized competitors and a broader one. They also consider the state of the economy, overall employee compensation in the company and finally, performance.”

Robin Ferracone, CEO for compensation consultancy Farient Advisors, agrees peer group benchmarking has inflated pay for top executives at U.S. companies, but says the challenge is finding an alternative. She cites insurer RLI Corp.’s use of “sharing ratios” as one approach. “They share profits with their top executives,” Ferracone says, “so if the company does well, the executives do well.” 

Another idea: Benchmark CEO pay against what companies pay lower-ranked executives, whose skills tend to be less company-specific and more transferrable, Ferracone says “I’m thinking of trying this idea on some of the boards I work with.”

 

For previous coverage, see More Disclosure on Compensation and CFO Pay Survey Exclusive.

 

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