The magic of peer groups

News Brief

By Cydney Posner

An article in the WSJ highlights the potential for misuse and manipulation of peer groups in benchmarking executive pay, describing recent studies demonstrating that companies select bigger and more complex rivals in compensation peer groups to boost executive pay.

The two studies cited show that companies tend to select peers with highly paid executives. One study of 657 companies, conducted by academics at the University of Maryland, also found that companies with corporate governance considered weak by experts, such as where the CEO also serves as board chair or where directors serve on multiple boards, are more likely to choose highly paid peers. The article notes that this problem is compounded by board decisions by approximately 40% of companies to target pay at levels above median, resulting in a continual ratcheting up of pay levels.

A second study, led by academics at Boston University, compared the peers chosen by more than 1,000 companies against "expected" peer groups chosen by a computer, based on a company's industry, size, performance and other factors. For example, Tootsie Roll Industries Inc. which reported $496 million in sales last year, identifies as a peer Kraft Foods Inc., where sales were $42.2 billion, about 85 times higher. All 12 of Tootsie Roll's "peers" reported higher revenue than Tootsie Roll, and median CEO pay at those companies was $5 million. However, when the computer chose 12 "expected" peers, replacing the big companies with smaller specialty-food makers, median CEO compensation totaled $1.3 million. The Tootsie Roll CEO was paid $2.5 million for the year. (Tootsie Roll's argument is that their chosen peers "may be viewed as competitors of Tootsie Roll from a product and executive talent standpoint" and that a compensation consultant helps the company adjust the pay data for a smaller cap company.) Tootsie Roll is apparently not alone, according to these studies. On average, the study authors estimate that the bias boosts pay about 5%, or $340,000 annually.

Quoting Charles Elson, head of the Weinberg Center for Corporate Governance at the University of Delaware, the article maintains that the studies highlight two current hot topics in executive compensation: the independence of board compensation committees and the role of compensation consultants, who often choose peer groups.

Related Contacts
Cydney Posner Special Counsel, San Francisco
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