The Advisors' Blog

Here is an interesting academic paper that was published this month in the Review of Finance. Four B-School profs looked at TSR and other “relative performance evaluation”-based awards – which in recent years constitute about one-third of the value of total compensation, according to the study. The professors first lay out why peer group selection can be fraught:

In practice, awards are designed by the board of directors often in consultation with the management. Frictions in contracting or lack of board oversight could enable the CEOs and executives to influence peer selection with the intention of increasing expected award payout and reducing award effectiveness thereby leading to a tension between the benefits of RPE from a theoretical perspective and the costs imposed by agency issues.

Boards or executives may also have other incentives to not design the awards exactly as theory predicts. For example, boards may feel, out of a sense of fairness, that executives should face some of the same risk in industry or market swings as investors do (Edmans, Gosling, and Jenter, 2021) and consequently select peers that do not filter out all common shocks to firm performance.

The use of peer groups to set pay levels, that is, competitive benchmarking, could also create inefficiency in RPE peer group selection. There is often significant overlap in firms included in the compensation and RPE peer groups. Firms selected for the compensation benchmark peer group either because they provide information about labor markets or are included to justify higher pay, may not be firms that are the best for filtering out common shocks to performance.

And here’s what their data revealed:

The custom group is significantly more effective than four plausible alternative peer groups at filtering out common shocks, lowering the cost of compensation, and increasing managerial incentives.

For RPE awards using a market index, we find some evidence that firms could have selected a custom set of peers with better filtering properties at a lower cost with similar incentives. For example, firms could have saved around $118,000 in present value terms, on average, for an RPE award had they chosen a custom group comprising their product market peers instead of a market index.

Although $118k is small potatoes in comparison to CEOs’ total compensation, it adds up across executives and over time. The question for companies that have been using a market index peer group is, would a switch be worth the internal & external communication efforts – and all that goes along with that? Check out this blog from last year for practical steps to select the right peer group – as well as the resources in our “Peer Groups” Practice Area.

– Liz Dunshee