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.

Few companies can be compared with Wal-Mart Stores Inc.

With $443.9 billion in sales for its fiscal year that ended Jan. 31, the Bentonville retailer is the biggest retailer in the world and typically No. 1 or No. 2 among corporations in any industry.

But when it comes to calculating how much Wal-Mart CEO Mike Duke will earn in total compensation, Wal-Mart’s board of directors’ compensation committee considers what similar companies are awarding their CEOs and compares that with Duke’s pay.

The practice, known as peer group compensation benchmarking, is the reason CEO pay has climbed to stratospheric levels in the last two decades, according to a recent study, “Executive Superstars, Peer Groups and Over-Compensation — Cause, Effect and Solution.”

“We find that peer group comparisons are central to the CEO ‘mega pay machine’ problem,” Charles Elson, an author of the study, said in a Sept. 24 news release. Elson is a director at the John L. Weinberg Center for Corporate Governance at the University of Delaware. Craig Ferrere, who is a fellow at the center, also is an author of the study.

Duke’s total compensation in 2011 was $18.33 million, down slightly from the $18.7 million he received in 2010, according to the company’s filings with the Securities & Exchange Commission. That includes salary, bonuses, stock options and awards and any “other compensation” that company reported to the Securities & Exchange Commission, as well as the value realized from exercising stock options in 2011.

By comparison, the CEO of Arkansas’ second-largest retailer, William T. Dillard II of Dillard’s Inc. in Little Rock, received $15.2 million in total compensation for 2011, a 275 percent increase from 2010. Dillard’s Inc.’s annual revenue, $6.3 billion in its most recent fiscal year, was only about 1.5 percent that of Wal-Mart, and its profit, $644 million, was less than 3 percent of Wal-Mart’s bottom line, $15.77 billion.

Wal-Mart’s compensation committee said in the company’s annual proxy statement that Duke’s compensation was in the top quartile when compared to CEOs in 23 retail companies that had more than $10 billion in annual revenue, such as Amazon.com Inc. of Seattle and the Kroger Co. of Cincinnati.

But his compensation was between the 50th and 75th percentile of peer groups when compared with 29 companies in the Fortune 100. Those companies included News Corp. of New York and Tyson Foods Inc. of Springdale. Wal-Mart’s committee also found the Duke’s pay was between the 50th and 75th percentile when compared to CEOs at the top 50 companies based on market capitalization. (See How Wal-Mart Determines Pay .)

The Associated Press reported in May that CEOs’ pay had climbed an average 6 percent compared with the previous year. The AP, which uses its own formula to calculate executive compensation, looked at 322 companies in the Standard & Poor’s 500. The median CEO pay, the AP found, was $9.6 million.

“The amount of money the CEO makes today is too much,” Ferrere told Arkansas Business last week. “The problem is the CEO is a product of an organization, and the pay should be based on what’s appropriate. I think we’ve got into a situation where it’s diverged from what it should be.”

But Scott Cross, managing director of Frederic W. Cook & Co., which provides executive compensation consulting services, defended the peer group practice. He said boards of directors have to look at what other companies are paying their CEOs to remain competitive. He also said companies look at other companies’ salary schedules to calculate the annual salaries for positions from accountants to CEOs.

“We have to understand what the competitive market is,” Cross said. “That would include companies of similar size, complexity [and] the scale of the company.”

But if the CEO isn’t performing at a high standard, “then you would expect for him or her to be paid at the lower end of this range of compensation,” Cross said.

Part of the reason for the high pay is the fear felt by company directors that their CEO will leave for another company, Ferrere said. “I think there’s a perception that if you don’t pay what everybody else is paying, then you’re going to lose your CEO,” he said.

But that’s not the case, according to the study.

“The findings are that CEOs don’t move and jump as often as we’d imagined,” Ferrere said. He said such moves had happened only in a handful of cases in the past 20 years.

The “Executive Superstars” study suggested that the CEO’s pay should be determined by internal company metrics, not based on what another company is paying its CEO.

A CEO’s eye-popping pay ultimately hurts shareholders and demoralizes the employees in the organization, Elson said in an interview with Arkansas Business. “If you can’t get your employees to get excited about the company, who will be?” Elson said. “How do you make profits?”

Showering the CEO with money also sends the message that “this guy is the only one that can run the company,” said Paul Hodgson, who studies executive compensation for GMI Ratings of New York. GMI Ratings researches environmental, social, governance and accounting-related risks affecting the performance of public companies.

Peer Group Metrics

After World War II through 1970, executive pay was “modest” and relatively flat, according to the compensation report. But after 1970, CEO pay started climbing.

“During the 1990s the annual growth rate in median pay reached about 10 percent,” the report said. CEO compensation rose from a median of $2.3 million in 1992 to $7.2 million by 2001, the study said.

One of the reasons for the dramatic increase in CEO pay was the practice of consultants relying on industry and market analysis to compare the executives’ pay to executives at other companies.

“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.

“The real victory would be placing discretion back in the hands of the boards and letting them determine what the appropriate thing to do is,” Ferrere said.

But that might not take place, said Hodgson, of GMI. “Changing the mindset of the compensation committee is not something that’s going to happen anytime soon,” he said. “I can’t see compensation declining.”

Say on Pay

In response to the 2008 financial crisis, the Dodd-Frank Wall Street Reform & Consumer Protection Act of 2010 shook up boardrooms.

One of the initiatives was instituting a “say on pay,” which requires public companies to give shareholders a regular opportunity to vote yes or no on the executive pay package. The vote, however, is nonbinding.

Ruel said the vote had encouraged a dialogue between companies and shareholders over compensation packages. “Companies are forced to respond,” he said.

But he said it hadn’t affected what CEOs were making. “CEO pay is still going up,” Ruel said.

 

 

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