New Evidence on Compensation Consultants and CEO Pay

The following post comes to us from Jenny Chu, Jonathan Faasse, and Raghavendra Rau, all of the Finance & Accounting Group at the University of Cambridge.

In 2013, CEOs in S&P 500 firms were paid, on average, over 200 times the average worker’s salary in their firms. To avoid or minimize public outrage, managers have a substantial incentive to obscure and try to legitimize their excessive compensation. One way of doing so is to have “independent” compensation consultants recommend higher pay to the board. However, prior literature has not been able to find significant evidence that hiring consultants leads to higher pay, partly because the information is only available after 2006 and most studies on this topic examine one or two years after 2006.

In July 2009, the SEC announced additional disclosure rules, requiring firms that purchase more than $120,000 in other services from their compensation consultants to disclose fees paid for both compensation consulting and other services. If the consultants were retained to solely provide advice on pay, fees did not have to be disclosed. The new rules came into effect for proxy filings after February 2010. In the paper, New Evidence on Compensation Consultants and CEO Pay, which was recently made publicly available on SSRN, we take advantage of this rule change to construct a large longitudinal sample of firms using compensation consultants over the period 2006-2012.

As additional services are typically paid for directly by senior management, the main objective of the additional disclosure rules is to ensure the independence of the compensation consultants hired by the compensation committee. However, we find that the consultant industry, especially those multi-service providers most threatened by the new disclosure rules, reacted quickly to this mandate. The largest multi-service providers such as Hewitt Associates, Mercer Partners, and Towers Watson spun off “independent” consulting businesses solely focused on executive compensation with former senior partners at the helm. The market share of specialist consultants jumped from 47% to 62% in 2010 and continues to rise to 79% in 2012. After the rule change, client firms that switched to specialist consultants paid their chief executive officers (CEOs) 9.7% more in median total compensation than a matched sample of firms that remained with multi-service consultants. We also find that, after the rule change, senior management is more likely to hire their own compensation consultant to work alongside one or more board-retained consultants. Compensation consultants retained solely by the board are associated with 12.9% lower median pay levels than a matched sample of firms with additional management-retained consultants.

Finally, we study the impact of hiring of compensation consultants at client firms that did not have consultants the year before. In 2006-2012, CEOs at firms that start hiring compensation consultants experience a 7.5% increase in median pay relative to a matched sample. In addition, an increase in CEO pay is associated with a subsequent lower probability of the compensation consultant being replaced by a competitor. Therefore consultants indeed have an incentive, on average, to recommend higher pay. Overall, our study finds strong empirical evidence for the hiring of compensation consultants as a justification device for higher executive pay.

The full paper is available for download here.

Both comments and trackbacks are currently closed.