Pay Harmony: Peer Comparison and Executive Compensation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday June 19, 2013 at 9:27 am
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Editor’s Note: The following post comes to us from Claudine Gartenberg of the Department of Management and Organizations at New York University and Julie Wulf of the Strategy Unit at Harvard Business School.

In our paper, Pay Harmony: Peer Comparison and Executive Compensation, which was recently made publicly available on SSRN, we find evidence consistent with the presence of peer comparison influencing pay policies for executives inside firms. Our underlying approach is to measure changes in pay co-movement, disparity and productivity using a 1992 SEC ruling that mandated greater disclosure of top executive pay. We argue that this ruling led to greater awareness of pay and, hence, greater peer comparison throughout all managerial ranks, particularly in non-proximate managers who had natural information barriers prior to the ruling.

We present the results of three analyses that, taken together, support the argument that firms’ pay policies respond to peer comparison and concerns about internal equity. In general, we find evidence that pay variance within firms, pay distance between managers and division productivity all increased during this period. However, we find that these measures increased less among firms and managers that were more affected by the 1992 SEC disclosure rule. Specifically, after the new regulation, we find increases in PRS (pay-referent sensitivity)—or greater co-movement of division manager pay—and decreases in PPS (pay-performance sensitivity) in geographically-dispersed firms, but not in concentrated firms.

Notably, these changes occur in the two-year period following the rule change, with no observed pre or post trends. We also find these results to be stronger among firms with less pay disclosure prior to the rule. We find that residual pay distance between pay of managers within firms increases after the 1992 SEC ruling, consistent with an overall trend toward greater pay disparity within firms. But we also find that distance increases less between managers of divisions located in different states relative to managers located in the same state, who were likelier to have been sharing pay information prior to the rule change.

Finally, in our most exploratory analysis, we find that division productivity in dispersed firms increases less after 1992 relative to divisions in concentrated firms and that this effect is driven by managers at the low end of the wage distribution for division managers. Altogether, our findings suggest that horizontal wage comparisons within firms and concerns for “pay harmony” affect firms’ policies on setting pay for executives and that firms face a tradeoff between the incentive effects of performance pay and the effects of peer comparison that arise from unequal pay.

The unique contribution of the paper is that it demonstrates how firms’ pay policies respond to concerns about internal equity, which, to our knowledge, has not been documented elsewhere. This research also raises questions for future research on the costs of pay disclosure and on labor markets more generally. What are the equilibrium consequences of the changes in wage contracts resulting from increased pay disclosure? From the firm’s perspective, these consequences may range from pay ratcheting to aggregate shifts in worker effort or firm-specific investments and turnover. Each of these changes, in turn, may have performance consequences for firms. From the employee’s perspective, increased pay disclosure may influence decisions to join firms and shift the relative importance of internal and external benchmarks, thereby having larger labor-market consequences. Aside from the contributions in this paper, these areas represent potentially fruitful avenues for further research as we broaden our understanding of peer influence within firms.

The full paper is available for download here.

 

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