Are executive pay peer group benchmarks the new credit ratings?

New research from the Investor Responsibility Research Centre Institute (IRRCi) suggests that over-dependence on peer group benchmarking for setting executive pay is the root cause of pay inflation in the USA and that a holistic, business-centric approach to setting reward is needed by boards, investors and regulators, including the courts.

For investors, the study reveals a need to move away from formulaic peer group analyses in judging compensation packages. Instead they should hold directors accountable for their pay setting judgement. “Shifting from the peer benchmarking process certainly isn’t the total fix, but moving towards an internal metric approach has the potential to contribute to solving the compensation problems that plague many public corporations,” said Jon Lukomnik, IRRCi executive director.

The study “Executive Superstars, Peer Groups and Over-Compensation – Cause, Effect and Solution” claims to be the first to document that peer group benchmarking is now so widely used that it has become the de facto standard and enshrined in US federal regulations, even though it was never designed to determine CEO compensation. The alternative, it is suggested, is a more “reasoned approach” to setting pay which takes a “whole company approach”. The authors suggest that this will not only result in more realistic pay setting but will result in improved board oversight and a healthier company.

“We find that peer group comparisons are central to the CEO ‘mega pay machine’ problem,” said study co-author Charles Elson, chair in Corporate Governance and director of  the John L. Weinberg Center for Corporate Governance at the University of Delaware. “Even the best corporate boards will fail to address executive compensation concerns unless they tackle the structural bias created by external peer group benchmarking metrics. “We find that boards should measure performance and determine compensation by focusing on internal metrics. For example, if customer satisfaction is deemed  important to the company, then results of customer surveys should play into the  compensation equation.  Other internal performance metrics can include revenue growth, cash flow, and other measures of return,” Elson explained. “This report is unique in that it takes a pragmatic approach to executive compensation theory, and begins with an examination the peer group process,”

Commenting on the study, co-author Craig Ferrere, the Edgar S. Woolard Fellow in Corporate Governance at the Weinberg Center said:”These findings have profound implications for CEOs, directors, and investors, It indicates that corporate boards need to de-emphasize peer grouping, and increase the emphasis on their company and executive accomplishments.  Companies are better served when directors use discretion – both up and down – in setting compensation structures and levels.”

The authors argue that:

• Theories of optimal market-based contracting are misguided because they are based on the notion of vigorous, competitive markets for  transferable executive talent;
• Even boards comprised of the fiduciaries faithful to shareholder interests will fail to reach an agreeable resolution to compensation when they rely on the flawed and unnecessary process of peer benchmarking;
• Systemically, a formulaic reliance on peer grouping will lead to spiraling executive compensation, even if peer groups are well constructed and comparable; and
• The solution is to avoid arbitrary application of peer group data to set executive compensation levels. Instead, compensation committees must develop internal pay standards based on the specific company, its competitive environment and its dynamics. Relevant considerations include an executive’s current and historic performance and internal pay equity. Some reference to peer groups may be warranted, but the compensation process must maintain the flexibility necessary to arrive at a reasonable approximation to what is absolutely necessary to retain and encourage talent.  

Given the current state of regulatory change in the EU, this research is a timely and welcome contribution to the stewardship debate. It’s conclusions also underpin the Manifest Total Remuneration Asssement framework which takes a multi-dimensional approach to understanding the governance of pay-setting rather than a reliance on raw quantum data.  The framework has been in place for over 18 months and has demonstrated strong performance for investors looking for objective and evidence-based approach to judging remuneration committee performance.

If you would like more information about Manifest’s approach to say on on pay please email: info@manifest.co.uk or call +44 1376 503500

Last Updated: 23 September 2012