Home > Compensation > What´s the best way to compare the Ceo pay?

What´s the best way to compare the Ceo pay?

Gretchen Morgeson wrote in September 22nd, (1), that there should be a better way to compare Ceo pay than that of putting it in relation to the median or average pay of all the company employees, (the Sec has been mandated in the USA to introduce that disclosure obligation for public firms). Companies in different sectors and countries, with different sizes, and with different human capital component in the workforce would for sure show different ratios, but the measure will probably not be very useful, except for media disclosure, exposure and debate. He instead proposes regulators, Corporate Governance practitioners and company departments to focus on Peer Groups, so as to improve the way they are used. As he said, 86% of companies in the S&P 1500 index used them.

 

In the era of Big Data, Equilar, a company that provides Compensation data and advice, builds Peer Groups for companies on the base of more than merely sector and revenue level. It uses Social Media and certain algorithms to select companies into those groups, as a result of them being perceived as connected through their existence in social media.

 

Using Peer Groups stems from the belief that there is a market for top executives and Ceos, so that they are able to profitably move from one company to another with a full transfer of their skills to the following firm. This is something that has been denied by Charles M. Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, and Craig K. Ferrere, one of its Edgar S. Woolard fellows, (2). Accordingly Elson and Ferrere believe Peer Groups have been responsible for a huge wealth transfer from shareholders to executives and particularly Ceos, among other consequences.

 

In “Punting Peer Groups: Resolving the Compensation Conundrum”, Elson and Ferrere propose an alternative method, consisting in an efficient negotiation process in which objective metrics would be brought in from the executive`s past actions so that a fair compensation is fixed, (previous executive influence on profitability, stock price evolution and so on). This is a task for independent and efficient Conpensation Committees, they argue.

 

But it is true that Peer Groups continue to be majoritarily used by firms when designing the structure of Ceo pay and determining its level. Albuquerque, De Franco and Verdi show that there is a certain biais in how the groups are selected; in fact, they choose peers that pay big compensation packages to their top executives. This might end in an ever increasing Ceo pay. But they find that there is a correlation between this higher pay and Ceo talent so attracted to the company. In spite of this, very often the peer groups are selected with the only aim that their use allows to increase the level of payment to be granted to top executives.

 

 

How can a peer group be selected in order for it to be an efficient tool allowing the firm attract and retain talent without incurring in over compensation?

 

Firstly, disclosure of peer groups is a necessary policy to be implemented by regulators; nevertheless, offering disclosure has not been enough to avoid bigger than necessary compensation for top executives, as it has been explained by Michael Faulkender and Jun Yang, (4). Moreover, they argue that firm opportunistic behavior became even more abusive after disclosure was imposed by regulators in the USA, in 2006. On the same topic, Claudine Gartenberg and Julie Wulf argue that discloruse has a comparison effect which cuases compensation for managers in global firms to stay closer to each other, (in different geographies, divisions and functions), (5).This is similar to the ratcheting effect of peer groups, as gaming the groups allows for firms with highly paid Ceos to join the group while those with low paid Ceos usually are excluded.

 

So, appart from disclosure, something else is needed. How do boards need to build their peer groups. Aubrey Bout and Brian Lane, from Pay Governance, introduce several proposals: (6)

 

1)      Your company`s particular features need to be considered. Industry, size, product portfolio, customer base, regulation, business cycle, brand value, internationalization, among others.

2)      Year on year consistency must be kept, and changes need to be carefully justified.

3)      Cualitative metric need to be used so as to reflect the Ceo labor market, but quantitative tools are critical.

4)      The peer group building process needs to be separated from the compensation designing one.

5)      The peers of the peers should at least be analysed, so as to avoid not necessary mistakes.

6)      Peers` size should be between 0.5 and 2 times, in general, the median corresponding to the current company size. This allows to attract bigger companies` s talent, which is necessary for growing firms. Besides, compensation could target a similar % to the one showing the company`s percentile in terms of size.

7)      Use a second peer group to benchmark pay practices.

8)      Disclose your practices to shareholders.

9)      Don`t limit to peer groups when designing pay levels. Internal equity, individual performance and other aspects should be considered.

10)  Once your peer groups is made, use it efficiently, not only when building your compensation structure.

 

 

(1)   “A Better Way to Compare C.E.O. Pay”, by GRETCHEN MORGENSON,

http://www.nytimes.com/2013/09/22/business/a-better-way-to-compare-ceo-pay.html?_r=0

 

(2)   “Executive Superstars, Peer Groups and Over Compensation: Cause, Effect and Solution”, http://sites.udel.edu/wccg/files/2012/01/Executive-Superstars-Peer-Groups-and-Overcompensation-Cause-Effect-and-Solution-2.pdf

 

(3)   “Peer Choice in CEO Compensation”, in http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1362047

 

 

(4)   “Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking”, at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1786109

 

 

(5)   Pay Harmony: Peer Comparison and Executive Compensation, at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2256704

 

(6)   Smart Compensation – Developing & Using Peer Groups, at https://www.worldatwork.org

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