It seems like executive compensation consultants come from Lake Wobegon, where “all the women are strong, all the men are good looking, and all the children are above average.”
I think executives should be compensated for out-performing their peers. They shouldn’t be punished for a negative performance due to external forces if they still out-performed their peers. Further, they shouldn’t be rewarded for a positive performance, if they under-performed their peers.
The magic is in picking the peer group to compare. Ideally, a peer group should include companies that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Of course matching all of those characteristics would lead to a very small group for comparison.
In an article in the Wall Street Journal, Cari Tuna points out that Tootsie Roll Industries used Kraft Foods as a peer for deciding how much to pay its executives. Tootsie had $496 million in sales and Kraft had $42.2 billion in sales.
A study by Ana Albuquerque of Boston University examined what needs to go into selecting the peer groups. She found that having the the same industry and size quartile shows the best evidence for creating a relative peer group for executive compensation. In a second study, she found that companies tend to choose peers that pay their CEOs more, which in turn translates into firms paying their CEOs more.
In their study, Michael Faulkender of the University of Maryland and Jun Yang of Indiana University came to the conclusion that “compensation committees seem to be endorsing compensation peer groups that include companies with higher CEO compensation, everything else equal, possibly because such peer companies enable justification of the high level of their CEO pay.”
You can also add into the mix that the company may not want to seen as having a CEO who is below average. If your CEO is below average, then your company may be below average.
If you’re a CEO of a public company, it’s getting harder and harder to be below average.
References:
- Picking Big ‘Peers’ to Set Pay by Cari Tuna for The Wall Street Journal
- Compensation Peer Groups by Michael Faulkender of the University of Maryland and Jun Yang of Indiana University in HLS Forum on Corporate Governance and Financial Regulation
- Faulkender, Michael W. and Yang, Jun,Inside the Black Box: The Role and Composition of Compensation Peer Groups(March 15, 2007). AFA 2008 New Orleans Meetings Paper. Available at SSRN: http://ssrn.com/abstract=972197
- Peer Firms in Relative Performance Evaluation by Ana Albuquerque of Boston University in HLS Forum on Corporate Governance and Financial Regulation
- Albuquerque, Ana M.,Peer Firms in Relative Performance Evaluation(March 26, 2009). Journal of Accounting & Economics (JAE), Forthcoming. Available at SSRN: http://ssrn.com/abstract=1368893
- Albuquerque, Ana M., De Franco, Gus and Verdi, Rodrigo S.,Peer Choice in CEO Compensation(July 21, 2009). Available at SSRN: http://ssrn.com/abstract=1362047
- Ethics in CEO Compensation by Chris MacDonald on The Business Ethics Blog
- CEO Pay and the Lake Wobegon Effect – previous post
- CEO Pay and the Lake Wobegon Effect by Rachel Hayes and Scott Schaefer of the University of Utah in the Journal of Financial Economics.