Compensation Peer Research Articles

Obscured Transparency? Compensation Benchmarking and the Biasing of Executive Pay

The disclosure of compensation peer groups is argued to provide shareholders with valuable information that can be used to scrutinize CEO compensation. However, research suggests that there are substantial incentives for executives and directors to bias the compensation peer group such that the CEO can extract additional rent. Analyses of eleven years of comprehensive data on compensation peer groups demonstrate that the average firm uses an upwardly biased peer group. The size of the bias is positively associated with poor firm performance and with the amount of structural ambiguity regarding the peer group that best matches the focal firm. Both of these relationships imply that firms select peer groups strategically in order to justify higher pay for the CEO. More importantly, upward bias in compensation peer groups is highly predictive of an increase in CEO compensation suggesting that there is a strong incentive for CEOs to introduce upward bias into the peer group. Finally, while average peer group bias has gone down in recent years, the predictive effect of bias on pay has gone up. These findings call into question the practical impact of recent efforts to introduce greater transparency into the process for determining executive compensation.

Learning about the Details in CEO Compensation

I document the richness of CEO compensation packages and show that boards learn about the desirability of the many complex package features through observing how these features are associated with firm performance. I first capture the detailed features of plan-based awards for CEOs of the largest U.S. public firms in a vector with more than 1,300 elements. I then demonstrate the complexity of boards' decisions on adding and dropping the detailed features. I hypothesize that boards learn about the efficacy of complex features by observing their correlation with performance—both at their own firms and at other firms. To test these hypotheses, I measure the similarity between any two compensation packages using a metric that assigns a shorter distance to more similar packages. My results support my learning hypotheses: firms that perform well in the current year award similar packages to their CEOs in the following year, whereas firms that perform poorly significantly change their packages in the following year; moreover, firms adjust their own CEO compensation packages to be more similar to that of well-performing firms, and less similar to that of poorly performing firms. These results hold after controlling for the effects from compensation peer firms, compensation-consultant sharing firms, board interlocking firms, and product market peers. I further show that a focal firm experiences better performance when its CEO compensation package becomes more similar to those used by its well-performing compensation benchmark firms. This paper demonstrates the importance of capturing the multi-dimensional details of CEO plan-based awards and studying changes in compensation packages in a holistic manner.

Executive Compensation and Aspirational Peer Benchmarking

Small firms provide an excellent, yet previously unexamined, laboratory for studying the controversial practice of compensation benchmarking since small firms have the opportunity to benchmark against `peers' whose executive compensation eclipses their own. Using a comprehensive, hand-collected dataset of explicit peer group relationships, I document that small firms engage in upward compensation benchmarking to a much greater degree than large firms do. In contrast to the prior literature studying larger firms, small firms choose aspirational peers that reflect their executives' shifting opportunity sets. For these firms, compensation benchmarking is indicative of future growth and performance, and the rate at which pay adjusts toward peer levels is sensitive to the transferability of managers' human capital. Contrary explanations that peer benchmarking is prone to agency problems are not supported by the data. Overall, the data suggest that growing and outperforming small firms strategically and preemptively use upward benchmarking to adjust pay in an effort to retain valuable managerial talent.

Compensation Contagion: The Role of Peer Benchmarking

We show that increases in CEO compensation at new S&P 500 members affect CEO compensation at other firms through compensation peer benchmarking. This compensation contagion propagates via three channels. Direct competition for managerial talent forces firms to respond to peers’ pay increases. Star chasing, which involves adding new S&P 500 members to compensation peer groups to justify higher pay, is associated with weak corporate governance. The peer-of-peer channel relies on indirect compensation peers and is most influential overall. Interestingly, we find minimal downward pressure on CEO compensation from companies removed from the S&P 500, confirming the asymmetric nature of contagion.

Benchmarking, Incentive Rebalancing, and the Influence of Labor Market Competition on CEO Equity Grants

We examine the extent to which participation constraints influence CEO annual equity grants. Studying CEO equity grants over the period 2006-2016 and using equity grants to compensation peers as a proxy for the reservation equity grant level, we find that the reservation wage in equity is a determinant of the magnitude of equity grants. We also find that firms are more likely to meet the peer grant levels when there is higher labor market competition and when the firm discloses that key personnel is a risk factor. CEO turnover is more likely when the firm grants equity below the peer level. Further, firms are less likely to meet peer equity grant levels and increase cash compensation when the CEO holds a large portfolio of equity incentives. Overall, the results suggest that the participation constraint influences annual equity grants and that firms consider the potential costs of providing too much equity.

Compensation Benchmarking and The Peer Effects of Say on Pay

We document that firms whose compensation peers experience weak say on pay votes reduce CEO compensation following those votes. Reductions reflect proxy adviser concerns about peers' compensation contracts and are stronger when CEOs receive excess compensation, when they compete more closely with their weak-vote peers in the executive labor market, and when those peers perform well. Reductions occur following peers' disclosures of revised pay and are proportional to those needed to retain firms' relative positions in their peer groups. We conclude that the spillover effects of shareholder voting occur through both learning and compensation targeting channels.

CEO Marketability, Employment Opportunities, and Compensation: Evidence from Compensation Peer Citations

Mandatory disclosure of CEO compensation peers signals potential outside opportunities for the cited CEOs by revealing which companies view them as viable executive candidates. CEOs cited often as compensation peers – especially by larger firms, which represent attractive employment opportunities – are more likely to leave for better positions or receive compensation increases. Equity-based awards following cites by larger firms have shorter vesting periods, suggesting these CEOs gain negotiating power relative to their boards. The disclosure requirement enhanced labor market transparency and led to higher compensation for highly cited CEOs without penalizing less cited CEOs, putting upward pressure on CEO compensation.

Relative peer quality and firm performance

We examine the performance impact of the relative quality of a Chief Executive Officer (CEO)’s compensation peers (peers to determine a CEO's overall compensation) and bonus peers (peers to determine a CEO's relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO's relative peer quality (RPQ). We find that firms with higher RPQ earn higher stock returns and experience higher profitability growth than firms with lower RPQ. Learning among peers and the increased incentive to work harder induced by the peer-based tournament contribute to RPQ's performance effect.

Relative Peer Quality and Firm Performance

This study examines the performance impact of the relative quality of a CEO’s compensation peers (peers selected to determine a CEO’s overall compensation) and bonus peers (peers selected to determine a CEO’s relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO’s relative peer quality (RPQ). We find that firms with higher RPQ tend to earn superior risk-adjusted stock returns and experience higher profitability growth compared with firms that have lower RPQ. These results cannot be fully explained by a CEO’s power, compensation level, intrinsic talent, nor by a board’s possible motivation to use peers to signal a firm’s prospect. Learning among peers and the increased incentive to work harder induced by the peer-based tournament, however, might contribute to RPQ’s positive performance effect. Preliminary evidence also shows that high RPQ is not associated with increased earnings management or increased risk-taking behaviors.

Relative Peer Quality and Firm Performance

​This study examines the performance impact of the relative quality of a CEO’s compensation peers (peers selected to determine a CEO’s overall compensation) and bonus peers (peers selected to determine a CEO’s relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO’s relative peer quality (RPQ). We find that firms with higher RPQ tend to earn superior risk-adjusted stock returns and experience higher profitability growth compared with firms that have lower RPQ. These results cannot be fully explained by a CEO’s power, compensation level, intrinsic talent, nor by the board’s possible motivation to use peers to signal a firm’s prospect. Learning among peers and the increased incentive to work harder induced by the peer-based tournament, however, might contribute to RPQ’s positive performance effect. Preliminary evidence also shows that high RPQ is not associated with increased earnings management or increased risk-taking behaviors.

Financial Reporting Quality and Peer Group Composition

Firms often compose peer groups to benchmark the compensation package of the CEO and/or to benchmark the performance of the firm as part of a relative performance evaluation. When justifying the composition of the peer group, firms often claim that the peer firms are similar with respect to accounting-based and market-based measures. An implicit assumption in this argument is that the accounting numbers of the potential peer firms are accurate. In this study, we examine the relationship between financial reporting quality of a potential peer firm and the probability of being included in the peer group of another firm. We hypothesize that firms with weaker financial reporting quality are less likely to be included in the peer group of another firm because of the increased information asymmetry between the potential peer firm and the selecting firm and the potential contagious effects of selecting a firm with weak financial reporting quality. Based on data about the composition of compensation and performance peer groups of the S&P 900 firms from 2006 until 2011, we document that firms with weaker financial reporting quality are, after controlling for the known determinants of peer group composition, less likely to be included in the peer groups that are used to benchmark the compensation package of the CEO and/or the performance of the firm. Additional tests suggest that this effect is driven by the increased information asymmetry and the potential contagious effects as developed in our theory.

Impression Management and the Biasing of Executive Pay Benchmarks: A Dynamic Analysis

We study the selection of peers into compensation peer groups reported by U.S. corporations. Securities and Exchange Commission (SEC) regulation requires firms to report these peer groups which are used by investors and shareholders to benchmark the compensation of CEOs. Building on a novel, dynamic analysis of more than 1,400 compensation peer groups since 2006, this paper presents new evidence that compensation peer groups are biased upwards relative to neutrally chosen “natural” peer groups. This upward bias is masked by several factors including normative selection on other criteria than compensation and the strong negative relationship between bias and the percentile at the named peer group at which the CEO is compensated. We find that adjustments to compensation peer groups are often better explained as bias-maintaining impression management than as structural adjustments to align peer groups more closely with the normative principles for peer group selection. We also find that peer group bias cannot generally be explained away as a reward for CEO talent. Our research suggests that although the SEC regulation was intended to minimize rent extraction, it has given firms a tool to manage impressions of shareholders and justify excessive pay.

Compensation Peer Groups and Their Relation with CEO Pay

ABSTRACTUsing a sample of S&P 1500 firms, we examine the selection of peer groups to set executive compensation. We document that the researcher-defined pool of potential peers significantly influences whether one concludes that the selection of peers is opportunistically biased to increase sample firm pay. With a broad pool of potential peers, opportunism seems more evident but when the potential peers are culled to a group that might better reflect the CEO labor market, selection appears less opportunistic. This finding is reinforced when we examine and find that differences in economic or compensation characteristics are largely unrelated to sample firm pay, even in settings in which we would most expect opportunism.

Peer group ties and executive compensation networks

Publicly traded firms in the US typically determine C.E.O. compensation by benchmarking the pay of their C.E.O.s against the pay of C.E.O.s in “peer” firms. Consequently, executive compensation is influenced not only by firm-level characteristics, but also by the selection and actions of the firm’s immediate peers as well as by the structure of the executive compensation network overall. Analyzing compensation peer group choices made by the same 1183 firms for F.Y. 2007, 2008 and 2009, we find that while the typical compensation peer is similar in size and industry to the firm that chose it, deviations from this norm are common, especially among larger firms, and tend to be towards larger firms with better paid CEOs. Further analysis shows that firms who pay CEOs well relative to the pay that would be predicted from their revenues, return on assets, and industry tend to have greater aspiration bias in their group of named peers.

Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking

Firms routinely justify CEO compensation by benchmarking against companies with highly paid CEOs. We examine whether the 2006 regulatory requirement of disclosing compensation peers mitigated firms' opportunistic peer selection activities. We find that strategic peer benchmarking did not disappear after enhanced disclosure. In fact, it intensified at firms with low institutional ownership, low director ownership, low CEO ownership, busy boards, large boards, and non-intensive monitoring boards, and at firms with shareholders complaining about compensation practices. The effect is also stronger at firms with new CEOs. These findings call into question whether disclosure regulation can remedy potential problems in compensation practices.

Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking

Firms routinely justify CEO compensation by benchmarking against companies with highly paid CEOs. We examine whether the 2006 regulatory requirement of disclosing compensation peers mitigated firms’ opportunistic peer selection activities. We find that strategic peer benchmarking did not disappear after enhanced disclosure. In fact, it intensified at firms with low institutional ownership, low director ownership, low CEO ownership, busy boards, large boards, and non-intensive monitoring boards, and at firms with shareholders complaining about compensation practices. The effect is also stronger at firms with new CEOs. These findings call into question whether disclosure regulation can remedy potential problems in compensation practices.

Peer Group Ties and Executive Compensation Networks

Publicly traded firms in the U.S. typically determine C.E.O. compensation by benchmarking the pay of their C.E.O.s against the pay of C.E.O.s in “peer” firms. The naming of particular peer companies by individual firms constitutes a supra-firm relational structure (network) in which an individual firm’s executive pay setting is embedded. As such, the compensation structure and level for any one executive at any one firm is influenced not only by firm-level characteristics, but also by the selection and actions of the firm’s immediate peers, and by the structure of the executive compensation network overall. Analyzing 56,718 C.E.O. compensation peer group choices made by the same 1,183 firms for fiscal years 2007, 2008 and 2009, we find that while the typical compensation peer is similar in size and industry to the firm that chose it, deviations from this norm are common, especially among larger firms. When firms go outside their normative size/industry peer population, their choice is structured: they tend to choose peers larger and better paid than themselves. Simulations suggest that the bias is statistically significant in all three years, and in the 26-37% range, depending upon the particular benchmark location at which the bias is measured. Further analysis shows that firms who pay CEOs nearer the top of their natural benchmark distribution, and who pay their firms well relative to the pay that would be predicted from their revenues, return on assets, and industry tend to have greater aspiration bias in their group of named peers, which arguably is done to provide justification for the relatively high rate of compensation.

Are all CEOs above average? An empirical analysis of compensation peer groups and pay design

Companies can potentially use compensation peer groups to inflate pay by choosing peers that are larger, choosing a high target pay percentile, or choosing peer firms with high pay. Although peers are largely selected based on characteristics that reflect the labor market for managerial talent, we find that peer groups are constructed in a manner that biases compensation upward, particularly in firms outside the Standard & Poor's (S&P) 500. Pay increases close only about one-third of the gap between the pay of the Chief Executive Officer (CEO) and the peer group, however, suggesting that boards exercise discretion in adjusting compensation. Preliminary evidence suggests that increased disclosure has reduced the biases in peer group choice.

Compensation Peer Groups and Their Relation with CEO Pay

We examine whether companies select compensation peer groups opportunistically to increase CEO pay. Using 608 firms from the S&P 1500, 2,154 peer firms identified from their proxy statements, and a pool of potential peers representing the firm’s labor market in which it competes for talent, we find limited evidence that firms choose peer groups opportunistically. Although firms select bigger and better performing peer firms relative to other potential peers, only size has any power in explaining CEO pay. On the other hand, inconsistent with opportunism, sample firms select peers that are more similar to them on other economic characteristics, that use the same compensation consultant and that select the sample firm as a peer. Despite subjecting our analysis to a battery of tests, and even in subsamples where opportunism is more likely at play, we find little support for the conjecture that firms strategically select peer firms to influence greater CEO pay. Our evidence is more consistent with peer firms being used to benchmark CEO pay in a competitive labor market.

Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking

Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking