Comparisons to Peer Groups Hike CEO Pay

by Mark Friedman  on Monday, Oct. 15, 2012 12:00 am  

Charles Elson of the John L. Weinberg Center for Corporate Governance said pay continues to rise for CEOs.

“By the late 1990s, peer group comparisons were ubiquitous to the formulation of executive compensation,” the study said. “Hence ‘peer group’ metrics were born.”

The peer group method was sanctioned in 2006 when the Securities & Exchange Commission required companies to disclose the precise composition of company peer groups used in public company executive compensation formulas.

Lake Wobegon Effect

The use of peer groups is problematic because the companies chosen to be in the peer group can be manipulated, Elson said.

“Companies can expand their peer groups, and then they’re developing a new median that allows them to pay their CEOs more money,” said Greg Ruel, a senior researcher at GMI Ratings who studies CEO pay.

The result of using peer groups is skyrocketing pay for CEOs. “It’s an ever-increasing threshold just because you’re constantly trying to best the median, but you’re increasing what the median is,” Ruel said.

The boards typically set the compensation rates to arbitrary targets — for example, that of 50th, 75th and 90th percentiles of peer groups, the study said. “A blind reliance on these pay targets has resulted in a mathematically based upward pay spiral,” the study said. “It is referred to as the Lake Wobegon effect” — a reference to radio personality Garrison Keillor’s fictional hometown, where “all the children are above average.”

If all companies aspire to pay their CEOs at or above the median, “it is clear that pay will continue to rise significantly and indefinitely; there is an obvious upward bias.”

Putting the CEO’s pay below the 50th percentile is rarely, if ever, done, the study said.

If that happened, it would send the message that the CEO is one of the worst of his peers and would raise concerns about the executive’s position in the company, “possibly undermining that individual’s ability to lead effectively,” the study said.

Empowering Boards Urged

Ferrere said that a board of directors should use internal metrics to determine the pay of an executive. For some companies that might mean looking at net income or revenue growth, but those measurements should depend on the company, he said.

 

 

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