The Advisors' Blog

This blog features wisdom from respected compensation consultants and lawyers

August 17, 2010

Study: Boards Use Peers to Inflate Executive Pay

Broc Romanek,

Below is a recent article from the NY Times’ DealBook:

Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance. While the rate of pay increases was nearly 11 percent in one recent year, the study highlights one of the various ways that corporate boards go about determining huge compensation packages for executives.

Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more, according to the Economic Policy Institute. This sharp increase in income for chief executives, coming as wages for ordinary Americans remained relatively flat, has become one of the more perplexing questions in social science and business. Are chief executives that much more valuable now than they were 45 years ago?

Social scientists have looked at a number of reasons for the disparity in pay, with many believing that it has something to do with weak corporate directors simply giving into the demands of management, which are often leading the boards. The common answer as to why chief executives are paid so much money is that boards want to “retain talent” and fear losing their chief executive to a competitor. Compensation committees on boards hire consultants to advise them on how much other chief executives at rival companies are paid to make sure that they are not undercutting their own top executives.

Michael Faulkender of the University of Maryland’s R.H. Smith School of Business and Jun Yang of Indiana University’s Kelley School of Business, sought to answer these questions in a new study examining the use of comparable companies in the role of determining chief executive compensation. The study, “Inside the Black Box: The Role and Composition of Compensation Peer Groups” (an abstract is available here), found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.

“Boards do look at labor market practices, so this is not an entirely corrupted process,” Ms. Yang told DealBook. “They do look at industry, they do look at size, the past talent flows, their visibility in everything, so that’s still the major part in the peer choices.” “But on top of that, if you can choose between company A or company B, which are pretty similar except that A pays their C.E.O. a little bit more generously than B, the board members tend to choose the slightly better paid company as the peer,” Ms. Yang said.

The research showed that from 2006 to 2007 this selection bias toward the higher-paying peers led to a 10.7 percent increase in the median pay for chief executives for more than 600 companies in the Standard & Poor’s 500-stock index and S.&P. MidCap 400 index, equating to a median pay increase of $470,000. “If we see this each and every year, the compensation is going to go up and up,” Ms. Yang said. “You can call this an upward spiral, you can call this ratcheting up, but yes, it is going to go up.”

The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years. But this does not completely explain why boards believe that their chief executives are necessarily worth the extra cash. In the end, the boards may feel that they must do whatever it takes to make their chief executives happy, which at the end of the day may or may not be in the best interest of shareholders.