Time to Abolish Peer Grouping in Determining Executive Pay?

Catherine Dunn

Corporate Counsel

10-02-2012

In the ongoing debate over the size of executive compensation packages, a key determinant of CEO pay has become increasingly controversial: peer grouping—the process by which boards of directors set the CEO’s salary by benchmarking it against those at other companies. 

What, then, if boards were to (almost) abolish peer grouping altogether? That’s the argument in a new study by Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, and Craig Ferrere, a fellow at the center. “Simply put, peer group comparisons and median targeting are central parts of today’s ‘mega-pay machine.’ Any executive compensation reform must start there,” they write in “Executive Superstars, Peer Groups and Over-Compensation—Cause, Effect and Solution” [PDF].

Elson and Ferrere's critique comes on the heels of a contentious proxy season as far as peer groups are concerned. On one side, shareholders have been critical of the peers that boards choose—arguing that the selections skew pay. But so, too, have companies been critical of proxy advisory firms, which have taken to creating alternative peer groups and evaluating a company’s pay practices accordingly. By May, 52 companies had contested recommendations from Institutional Shareholder Services (ISS) on their pay practices—compared to 27 that had done so at the same time last year, according to the Wall Street Journal. 

Another survey of corporate directors speaks to those frustrations. The 2012 BDO Board Survey polled 72 board members at small cap companies, ranging in size from $250 million to $750 million in revenues. To be sure, they had a number of complaints about ISS: 75 percent believe that proxy advisory firms that advise shareholders about say-on-pay votes—and also consult with public companies—have a conflict of interest. Additionally, 75 percent of respondents believe that proxy advisory firms should be regulated by the government. 

Peer grouping was up for critique in the BDO study, too. “A majority (59%) of directors believe that the peer groups used by proxy advisory firms for executive compensation comparison purposes are not an accurate reflection of their company’s peers,” according to the findings. “When asked what was the most important criteria in determining a peer company for executive compensation purposes, industry (61%) was by far the most cited response.”  

Cue Elson and Ferrere, who believe peer groups are inherently problematic, no matter how they’re structured. 

The full study runs to 52 pages, and Elson’s own summary at the Harvard Law School Forum on Corporate Governance and Financial Regulation boils down to about a thousand words, so take your pick if you go straight to the source. But the authors' analysis, replete with an interesting history of just how peer grouping got started in the first place, centers on several main arguments. 

For one, no matter how well-selected a peer group may be, it will always contain an upward bias. That’s because boards aim to peg a CEO’s salary to the median and above—never below. That leads to something called “leapfrogging”: when one CEO in any given peer group is exceptionally compensated, that person’s salary raises the floor for everyone else. “One firm’s overpayment affects all the connected firms for which they are a peer,” Elson and Ferrere write.

Another reason peer grouping doesn’t work, they argue, owes to a faulty premise: the idea that CEOs can take their valuable skills to any other company, and therefore boards—mindful of marketplace competition—think they have to pay up to keep up. “The process is viewed as a practical means of ensuring that pay is consistent with an executive’s outside opportunities in the market for the purposes of retention and motivation,” they state.

But that’s just not the case, they say. In today’s highly specialized marketplace, a CEO’s acumen isn’t simply “transferable” from one corporation to the next. Far from it: “Reliance upon general managerial skills, principles, and techniques will not suffice,” Elson and Ferrere write. “The corporate superstar, excelling in every sphere of economic activity, is a myth.” 

Between the “myth” and the reliance on external benchmarking, pay is taking its toll, according to Elson and Ferrere: “While perhaps innocuous at first, the accumulated effect has been an unacceptable increase in the proportion of corporation earnings going to management rather than shareholders,” they write, adding: “This is a material concern—it is draining invested capital out of companies and straining the companies’ and the country’s social fabric.”