The Trouble with Peer-Pay Benchmarking for CEOs

One negative effect of using peer pay to determine a CEO's compensation can be that company morale is affected if employees view executive pay as being grossly out of proportion with their own, researchers report.

Thursday, May 2, 2013
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Relying heavily on competitive benchmarking in setting CEO compensation could be a costly misstep based on outdated and flawed rationale, according to researchers from the University of Delaware.

The study, "Executive Superstars, Peer Groups and Over-Compensation -- Cause, Effect and Solution," asserts that, contrary to common belief, executives are not frequently moving among top slots, and when they do, it's often with less-than-stellar results.

Looking at how other companies are paying rewarding their CEOs and then attempting to best the median leads to a "ratcheting up" effect, endlessly cranking COE compensations higher and higher, say the researchers, Professor Charles Elson and Research Fellow Craig Ferrere, both of the university's John L. Weinberg Center for Corporate Governance. fate of Ron Johnson, J.C. Penney's recently ousted CEO, shows that benchmarking should become a practice of the past, Elson says.

"While it used to be based on peer compensation, here, we're saying the starting point should be internal," says Elson, who also is the university's Edgar S. Woolard Jr. chair in corporate governance and center director. "This is better, because it can be consistent with the company's pay scale."

Johnson, whose resume includes executive experience at Apple and Target, was lauded as an innovator at first. Though the company paid Johnson about $50 million in stock alone to accept the post, the chain's sales plunged, according to the Wall Street Journal. After 17 months, he was let go.

"He was brought in as a star CEO," Elson says. "They paid him a lot of money and it didn't work out. It basically reflects what we found: sometimes, culture doesn't translate."

In the study, researchers compiled data on the CEOs of 1,500 companies over the last 30 years. Their findings: Top executives rarely leave for other companies. Among CEOs included in the study, only 27 left for another position, and most of those transplants failed. The researchers link the beginning of peer-group compensation and analysis to the post-World War II business environment of 1949, when a point system was developed to set compensation rates based on a globalized model.

Elson says embracing a new approach to compensation -- one not based on what peer companies are doing -- has liberating implications for human resources.

"Pay, rather than being externally developed, can be based internally. In other words, you'll design a compensation package around an internal scheme," he says. "From the HR perspective, you can be more consistent."

The researchers pointed out that one negative effect of benchmarking can be that company morale is affected if employees view executive pay as being grossly out of proportion with their own. They also found that, most often, CEOs are promoted from within.

Other studies, such as one from the consulting firm Spencer Stuart, arrive at similar figures: In 2012, 73 percent of newly appointed CEOs among the S&P 500 companies studied were internal placements, down from 78 percent in 2011.

"The idea now is: Look, if CEOs can't move like we thought they could, why are we compensating them based on peer pay? That fear [of not providing enough compensation to retain candidates] came from the board," Elson says. 

The challenge then, is finding the appropriate ratio to calculate CEO pay, Elson says.

But Ferrere says there is no simple or uniform formula.

"We tend to think that there are some objective metrics out there, but in the end, it's a complicated thing. You need people close to the issue to figure it out," he says. "From our perspective in academics, we can give guidance and advice, and at the end of the day, we hope people can adjust to what's most appropriate.

"I think they have their work cut out for them."

In summarizing the study in a publication for The Conference Board, a New York-based independent business research association, Elson and Ferrere write that benchmarking can bring a dangerous false sense of security.

"While metrics such as peer benchmarks are helpful, compensation committees must be careful not to be lulled into complacency by the sense -- or appearance -- of objectivity they provide. Boards should rely on their own judgment and independent analysis of the many subjective factors important to the design of an effective pay scheme," it says.

Some slow-down on executive paychecks and bonuses is materializing already, according to data from HR consulting firm Towers Watson. The analysis released April 16 was based on 270 S&P 1500 companies that filed proxies disclosing 2012 pay by late March.

In the data, the firm points to weakening company financial performance last year as one factor in a dip in salary increases (from 3 percent in 2011 to 2.8 percent in 2012), accompanied by a steep decline in annual bonuses, with 11 percent more CEOs receiving bonuses at or below target levels compared to 2011. The total pay for CEOs increased 1.2 percent in 2012, dropping from a 6.7 percent median increase for CEOs in 2011, the data shows.

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Todd Lippincott, leader of Towers Watson's executive compensation business for the Americas, says one explanation is say-on-pay, which allows shareholders to cast their vote on executive compensation.

"Beyond a weaker financial year for many companies, I think companies were being prudent given continuing economic uncertainty and headwinds," he says. "More broadly, I think companies have always been concerned with 'overpayment' and have sought to do the right thing."

Lippincott says the University of Delaware study doesn't fully explore the lack of transfers among COEs.

"Our main concern is that his research did not explore the reasons why CEO movement is so infrequent," he says. "Note that we did not say CEO turnover, because the rate of CEO turnover actually has increased this past year. The main issue is the lack of perceived fungibility of CEOs across industries. That would explain why you don't frequently see CEOs moving from one industry to another. For those who would wish to jump to a competitor, many CEOs have in place non-compete provisions that would prevent that from taking place. "

He says he does not think the research findings undermine the use of competitive benchmarking and that the process is not --- and should not be --- past practice.

"Both in new hire situations and in recurring CEO pay settings, compensation committees generally want to make sure their CEO is not paid too much so that the shareholders are disadvantaged, but paid enough to make sure the CEO remains engaged, preventing the great disruption that would take place if he or she was to leave," he says. "It's a difficult balance for committees, but one that is advised on both sides because both the CEO and the committee are aware of what peers are paying." 

However, with mandatory say-on-pay votes in its third year of implementation, Lippincott says companies should be able to exercise greater freedom to vary from the going rate.

"We think one of the biggest challenges is to avoid being beholden to the data and automatically conforming to market norms. For example, our data shows that the number of companies that use [total shareholder return] in their long-term plans has doubled over the past four years to almost half of the companies we reviewed.  In the face of this data, many companies would conclude this is a trend they need to mirror. But there is more to the story than simply adopting what is trendy, as these plans, for example, have their benefits but also their drawbacks," Lippincott says. 

"Drawbacks need to be considered and may lead to some different outcomes - for example tying equity awards to other financial measures, such as earnings growth, that may be better at meeting the company's unique need. Therein lies the opportunity - the opportunity for tailoring programs to the company's specific needs and strategies, in effect, paying for strategy.

"With generally calm seas surrounding most companies as it relates to say-on-pay, we think companies now have license to vary from market norms to a greater extent, especially when such variance may support the company's unique environment."

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