Relative Performance Evaluation and Related Peer Groups

The following post comes to us from Guojin Gong of the Accounting Department at Pennsylvania State University, and Laura Li and Jae Shin, both of the Accounting Department at the University of Illinois at Urbana-Champaign.

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.

We also find that firms consider both costs and benefits of RPE as an incentive mechanism when deciding to use RPE. Analyses of self-selected RPE peers lend support to the efficient use of RPE as well as a self-serving bias in forming RPE peer groups. In particular, RPE firms’ superior performance leads efficient contracting considerations to drive the selection of RPE peers, whereas underperforming RPE firms exhibit greater rent seeking behavior in the RPE peer selection process.

One limitation of our analyses is that we are unable to identify firms that use RPE implicitly without pre-committing to explicit RPE contracts. Future research could examine both explicit and implicit contracting to better understand RPE as an incentive device. Furthermore, while our study sheds light on target setting in executive compensation contracts, we may omit certain factors that boards consider in setting performance targets for executives. The peer selection bias we document, for example, may reflect boards’ conscious efforts to balance various factors in setting performance targets (Merchant and Manzoni 1989). Examining interactions between various factors would be an interesting avenue for future research.

The full paper is available for download here.

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