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.

…continue reading: Pay Harmony: Peer Comparison and Executive Compensation

Changes in the level and dispersion of CEO compensation since the early 1990s have triggered an increasingly heated debate over whether current compensation practices primarily reflect the equilibrium outcome of the CEO labor market or the power of entrenched CEOs. One factor in this debate is the practice of compensation benchmarking in which firms justify their CEO’s compensation by comparing it to the pay packages of a group of companies with highly paid CEOs. Firms rationalize this group by claiming they compete for managerial talent with those selected peer companies. In the paper, Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking, forthcoming in the Review of Financial Studies, we examine the dynamics of the peer benchmarking process. Specifically, we investigate whether the 2006 regulation requiring firms to disclose their compensation peer group members has mitigated opportunistic firm behavior in benchmarking against self-selected peer companies with highly paid CEOs.

…continue reading: The Dynamics of Compensation Peer Benchmarking

In the paper, Executive Superstars, Peer Groups and Over-Compensation — Cause, Effect and Solution, which was recently made publicly available on SSRN, we develop a pragmatic approach to understanding the run-up in CEO compensation over the past several decades. Rather than looking to markets or captured boards for the explanation, we argue that the actual mechanical process of peer benchmarking by which pay is set is the cause of the present controversy. From this perspective, we present what we believe will be an effective solution; additionally and collaterally, some interesting lessons about executive recruitment, particularly the CEO “superstar” culture, may be gleaned from our findings. We thank the Investor Responsibility Research Center Institute, which has long funded compensation research, for their financial support and helpful assistance in the development of this paper.

The piece makes a contribution to the executive compensation literature as it offers a novel explanation for the perpetual rise in CEO pay and suggests a significantly different solution to the compensation controversy. As boards have typically looked outside the organization to set CEO pay, we argue that this approach, known as “peer grouping,” is seriously flawed as it relies on the notion of an easy transferability of executive talent which empirically, is incorrect. Therefore, boards should look within the organization itself rather than to external comparators to create an appropriate CEO pay structure. We suggest that this approach should begin to resolve the CEO compensation problem.

…continue reading: Executive Superstars, Peer Groups and Over-Compensation

Introduction

Investors have for a number of years expressed concerns over pay disparities between that of the chief executive officer and the next highest paid executive at U.S. corporations. The State of Connecticut pension system gave voice in 2008 to these concerns by filing shareholder proposals calling for enhanced disclosure of how internal pay equity factors into the pay-setting process. The targeted corporations were receptive to those concerns and agreed to implement the pension fund’s substantive demands.

Moreover, credit ratings agency Moody’s suggests pay gap multipliers in excess of three times the pay of the second highest paid officer can adversely affect a company’s cost of capital and debt rating. A high ratio between CEO pay and compensation for other named executives can indicate the company is CEO-centric, with associated CEO succession risk, according to Moody’s. [1] The ratings agency acknowledges that high internal pay equity can be a reflection of a CEO’s influence and centrality to a company, though argues “such a large disparity may indicate … concentration of power in the CEO.”

…continue reading: Bridging the Pay Divide

Introduction

The enhanced executive compensation disclosures mandated by the U.S. Securities and Exchange Commission in 2006 have provided a significant new data set for investors and companies to analyze and benchmark pay practices across a broad set of U.S. corporate issuers.

Moreover, precisely how companies choose to benchmark their pay practices has received much attention following the outcry over Wall Street payouts and the recent promulgation of legislation requiring most U.S. issuers put their pay to a precatory shareholder vote.

Against this backdrop, Executive Pay Through a Peer Benchmarking Lens summarizes key findings from ISS Corporate Services’ study of almost 15,000 Def 14A filings over the past four years. Drawing on ISS’ executive compensation database, the focus of the analysis is on both pay levels as well as the processes by which companies benchmark their pay relative to peers.

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In the paper, Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts, forthcoming in The Accounting Review, we examine the explicit use of relative performance evaluation (RPE) and related peer groups based on S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules. Prior empirical research offers mixed evidence on the use of RPE in executive compensation contracts based on an implicit approach. The implicit approach infers RPE use by regressing executive pay on industry performance across a population of firms, and thus relies on simplified assumptions concerning RPE contract details. We demonstrate that a lack of knowledge of both RPE peer group composition and the link between RPE-based performance targets and future peer performance cloud inferences drawn from implicit tests. These findings highlight the limitations of the implicit approach and underscore the importance of incorporating explicit RPE contract details in testing for RPE use.

…continue reading: Relative Performance Evaluation and Related Peer Groups

Agency theory suggests that the compensation of chief executive officers (CEOs) should be linked to firm performance to motivate CEOs to maximize shareholder value. Further, the hypothesis of relative performance evaluation (RPE) states that the firm performance measure used in CEO pay should exclude the component driven by exogenous shocks. Despite much research in this area, the lack of consistent empirical evidence supporting the use of RPE in CEO compensation is an important unresolved puzzle. In my forthcoming Journal of Accounting and Economics paper Peer Firms in Relative Performance Evaluation, I study how the choice of peer group affects tests of RPE, which is a joint test of how incentives are granted and of what constitutes a peer group. Previous tests potentially lack power to detect evidence that supports RPE because peer groups chosen by researchers are incorrect. The challenge in choosing a RPE peer group is to identify the set of firms that are exposed to common shocks and share a common ability to respond to those shocks.

Ideally, a peer group should include firms that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Yet considering all such characteristics simultaneously is not practical because it could result in peer groups composed of too few firms, which would be too noisy to filter external shocks. In this paper, I show that industry and firm size capture many of these characteristics. Specifically, when peer groups consist of firms within the same industry and size quartile, my empirical results show systematic evidence supporting RPE usage in CEO pay. The analysis includes both the level and the growth of total compensation flow regressed on firm stock performance, peer stock performance, and control variables.

To compare with previous studies, I test whether RPE is used when measuring peer performance with two common peer group definitions, namely, the S&P 500 index and firms within the same industry. I fail to find consistent evidence of RPE usage with either peer definition. I also find no evidence that accounting returns substitute for RPE in stock returns, or evidence of RPE in accounting returns when using industry-size peers. Last, I test for the presence of RPE when peer groups are formed based on industry plus other firm characteristics, such as diversification, financing constraints, and operating leverage. The evidence is inconsistent with RPE when using such peer groups. Evidence exists to support RPE usage in the level and growth of CEO pay when peers are defined as firms in the same industry and growth options quartile. However, when both industry size and industry-growth options peer performance are included, the results show that only industry-size peer performance is filtered from CEO pay.

The full paper is available for download here.

Our forthcoming article in the Journal of Finance entitled The Geography of Block Acquisitions, extends the literature on geographic proximity by studying how corporate governance activities of block acquirers in targets and target announcement returns are affected when the acquirers are located near the targets.

Using a sample of 799 partial acquisitions in the U.S. during the 1990 to 1999 period, we find that:

The full paper is available for download here.