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Saturday, November 25, 2006

Where All the Peers Are Above Average...

Executive compensation is often set through comparisons to peer groups. But how are the peers chosen? Does the process yield defensible compensation levels?:

Peer Pressure: Inflating Executive Pay, by Gretchen Morgenson, NY Times: Like Lake Wobegon, Garrison Keillor’s fictitious Minnesota town where all the children are above average, executive compensation practices often assume that corporate managers are equally superlative. When shareholders question lush pay, they are invariably met with a laundry list of reasons that businesses use to justify such packages. Among that data, no item is more crucial than the “peer group,” a collection of companies that corporations measure themselves against when calculating compensation.

But according to a handful of pay experts..., many of these peer groups are populated with companies that are anything but comparable. They also say corporate managers themselves ... are selecting which companies make it into a peer group. And because these companies are often inappropriate for comparison purposes, their use has helped inflate executive pay in recent years. ...

[D]etails about exactly how peer groups are compiled have been kept under wraps. The worry among investors, of course, is that executives, consultants and directors simply cherry-pick peer-group members, thereby pumping up pay packages.

Current disclosure rules require neither the identification of companies in a compensation-related peer group nor the rationale behind their selection. Usually, the most a shareholder learns about companies in a compensation peer group is that they are in the same industry or of a similar size.

This ambiguity will change when new Securities and Exchange Commission disclosure rules go into effect on Dec. 15. The rules will require a corporation to reveal which companies it uses in its peer group and to provide an extensive description of its compensation philosophy. ... As a result, peer groups are likely to attract increased scrutiny...

Sometimes, compensation peer groups include companies that are not even in the same industry or are not of a similar size. ...[A]bout 10 years ago, big brand-name companies began measuring themselves against other household-name companies, even though they were not in the same industry. Companies that made it onto Fortune magazine’s list of “most admired companies,” for instance, began to compare their pay to others on the roster. Never mind that the connection was irrelevant...

The use of dueling peer groups — one to measure stockholder return, another to calibrate executive pay — is common in corporate America. But Paul Hodgson, author of “Building Value Through Compensation,” questions the practice. “Best practice would dictate that, if a compensation committee report is to include a graph showing the company’s relative performance to peers, those peers should be the same as the group actually used to test performance”...

Mr. Van Clieaf, the compensation consultant, said the composition of peer groups is usually more heavily weighted to larger companies, even though corporations typically look to companies smaller than themselves when they are recruiting top executives. This reality calls into question the oft-heard argument that outsized pay is based on market forces and that because companies have to jockey for the very best, enormous compensation deals are reasonable.

“Where would you really go to look for talent,” Mr. Van Clieaf asked. “Either at the second or third layer down at bigger companies or the No. 1 role at smaller companies. Do you really think the C.E.O. of Johnson & Johnson is going to go to work at Eli Lilly?” Even so, the pay handed out to executives at smaller companies — or to lower-level managers at larger concerns — are rarely included in peer groups...

Even if the groups aren't cherry-picked to include above average compensation levels, there is no reason to necessarily believe that compensation levels will mimic the market outcome and properly reward CEOs for their productivity.

Suppose the peer group is chosen properly so that the average compensation level of the peer group is not inflated relative to the firm's characteristics, and compensation is set accordingly. If all the other CEOs are paid more than is justified by economic fundamentals, then averaging their compensation packages simply replicates the bad result. Cherry-picking that drives compensation upward exacerbates the problem.

So while it is a step in the right direction to get the peer groups correct, there should be no presumption that doing so will produce CEO compensation that reflects the CEO's productivity and replicates the outcome of a competitive market.

    Posted by on Saturday, November 25, 2006 at 02:48 PM in Economics, Income Distribution, Market Failure | Permalink  TrackBack (0)  Comments (11)

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