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The Trouble with Benchmarks

 

Thanks to peer-group comparisons, C-suite pay levels are rising exponentially. But are they really that effective in correctly determining the proper levels of executive compensation?

 

Monday, October 22, 2012
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Benchmarks and peer-group comparisons are used commonly across many industries, and are prevalent in the HR world as well, particularly when it comes to salary and benefits. Market comparisons can help ensure that an organization is competitive in the marketplace and successfully recruit and retain staff in a variety of positions.

There is a critical assumption, though, that must be true to ensure that these peer-group comparisons achieve the intended results: parity. The positions being compared must be the same, or similar enough, to make a decision valid.

When it comes to CEO pay, according to some recent research, peer-group comparisons are built upon faulty assumptions that may be contributing to driving up the pay of CEOs around the country as well as internal disparities between CEO and other high-level executives' pay.

According to a new study published by the New York-based Investor Responsibility Research Institute, an over-reliance on peer-group compensation benchmarking is central to the persistent issue of rising executive pay in the United States.

The report, titled Executive Superstars, Peer Groups and Over-Compensation -- Cause, Effect and Solution, was written by Charles M. Elson and Craig K. Ferrere, with the John L. Weinberg Center for Corporate Governance at the University of Delaware.

"This new study makes it clear that peer grouping with minimal board discretion is a seriously flawed methodology even when the peer groups are fairly constructed," according to the institute.

In the report, Elson and Ferrere point out that, in setting the pay of their CEOs, boards invariably reference the pay of the executives at other enterprises in similar industries and of similar size and complexity.

"For this, compensation consultants are retained to construct a 'peer group' of such companies and survey the pay practices which are prevalent," the authors say. "Then, in what is described as 'competitive benchmarking,' compensation levels are generally targeted to either the 50th, 75th or 90th percentile. This process is alleged to provide an effective gauge of the 'market wage' which is necessary for executive retention."

That process, say the study's authors, is inherently flawed. 

The result: CEO pay is rising exponentially through these comparisons, resulting in companies -- and their shareholders -- paying more than they need to and a corresponding internal impact on pay disparity and resulting dissatisfaction and disincentives in the organization.

CEO skills, says Elson, "are really not transferrable." And, because of this, he and Ferrere posit that using CEO peer groups to determine CEO compensation is a foundationally flawed practice. CEO skills, unlike other C-level and staff positions, are simply not transferrable, they assert. They are company-specific.

"If that's true and there's very little transferability of talent, then the whole peer system has to fall," says Elson. "That's what is significant for HR folks. The peer system, vis-à-vis CEOs, can't sustain itself. It's based on a false premise. If the premise falls, the whole thing falls."

But compensation experts don't necessarily agree.

"Overall, I think the baseline that the authors suggest is oversimplified and outdated," says Todd Lippincott, the New York-based North America leader for executive compensation at Towers Watson.

"They seem to imply that boards are quite mechanistic and that they essentially take survey data and have a knee-jerk reaction to provide automatic increases," he says. "Our experience is that boards apply much more judgment and consideration in making adjustments to CEO pay, especially in the last several years where we have a more turbulent economy, more variance in company performance and where we have say on pay."

Gregg Passin, a partner with Mercer in New York, says he agrees with the report's premise that the CEO is a unique position. But, like Lippincott, he doesn't believe that peer-group information is the only input considered in making these decisions.

"Most companies, when they're looking for CEOs, pay what they think they need to get the right person to lead their organization and make it successful," he says. Peer group data is part of that determination, he says, but certainly not the only input. "Just because a peer group pays a CEO or any other executive a certain amount of money, that does not mean that that's the right answer for any particular company.

"We tell our clients this all the time: it's one piece of information that they need to take into consideration in determining pay levels for their executives," he says. "It needs to be looked at in the context of the company's business strategy, human capital strategy, internal-equity considerations, motivation, etc.

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"It's an important piece of information," he says, "but not the only one and certainly not the most important one."

Boards should never make decisions based on a single input, whether considering CEO pay or any other issue, says Passin. "I think any committee or board that does that and does that in isolation of their own specific circumstances, strategy and context, probably is not doing its job."

While Lippincott says that he would wholeheartedly support the report authors' recommendation that peer data should be one of a multitude of considerations, he says: "They're recommending something that is effectively status quo for most boards today."

So what does all of this mean for HR leaders?

"HR is responsible for everyone else's pay but the CEO's," notes Elson. But, he adds: "I think if HR can make this point clear to the CEO and to the board about this issue of transferability, I think they may then foster better negotiations between the board and the CEO. Ultimately, for the HR officer, that means a more rational pay scheme throughout the organization, which is helpful to the investors and to the company."

Ferrere agrees. "For HR people in particular, and for comp consultants, they can get back to what they really do, which is design pay that's appropriate for the company and get to the right results -- not to rely on some formulistic mechanism."

But, says Robin Ferracone, CEO of the independent executive-compensation consulting firm Farient Advisors in Los Angeles: "If I'm an HR head, I'm going to be questioning whether (the report's) suggestions are practical and what can be done from a practical perspective, because most of the time comp groups and directors feel as though peer groups give them some cover in coming up with their recommendations for the CEO."

For better or worse, says Ferracone, comparisons are here to stay. She recalls an interview she conducted with economist Dan Ariely, a behavioral economist, when writing her book Fair Pay, Fair Play: Aligning Executive Performance and Pay. "One of the things he says is that human beings are hard-wired to make comparisons. That's how they actually make decisions and that's how they can make decisions more quickly rather than slowly.

"I wrote about this in my book because it's just such an important fundamental human trait," she says. "So that's the other piece here: human behavior and efficiencies suggest that comparative analysis is one piece that needs to be done."

Ferracone says that she thinks Elson and Ferrere have done a good job of raising an interesting, relevant and valid topic, but says "they probably don't go far enough in resolving what to do about it."

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