Peer Group Choice and Chief Executive Officer Compensation

David F. Larcker is James Irvin Miller Professor of Accounting at Stanford Graduate School of Business; Charles McClure is Assistant Professor at the University of Chicago Booth School of Business; and Christina Zhu is Assistant Professor at the Wharton School at the University of Pennsylvania. Related research from the Program on Corporate Governance includes The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer (discussed on the Forum here).

Our new study examines the board of director choice of peer firms used in setting CEO compensation. One controversial question is whether selecting relatively large, highly paid peer firms is appropriate. The common rationale is that many firms want to attract and hire highly talented executives from larger firms with higher levels of CEO pay. However, governance activists and proxy advisors believe some firms select peers that are larger and/or have higher compensation levels simply to justify a high level of CEO pay.

We provide a different interpretation of peer group choice than prior research on this topic. Previous studies tend to conclude that peer group choice is a result of aspirational labor market incentives and that corporate governance considerations are of minor importance. However, prior research tends to focus on large firms that confront considerable scrutiny regarding their corporate governance. In such a sample, it will be difficult to observe whether governance considerations affect observable board of director decisions such as CEO compensation. Using a comprehensive sample with many small and medium-sized firms that are less subject to public scrutiny, we find that both aspirational and rent extraction motivations influence the selection of peer groups for setting CEO compensation.

In addition to substantially expanding the sample of firms, our study also shifts the unit of analysis from the selection of individual peer firms to the selection of a portfolio of peer firms. Although compensation committees clearly assess each individual firm for inclusion in the peer group, they are ultimately selecting a portfolio of firms that informs or justifies their choice for CEO compensation. The CEO compensation benchmark is often set at the median pay of the selected portfolio of peer firms.

To address this practical concern, we develop a new measure for assessing peer groups, denoted as Peer Portfolio Percentile (PPP), which mimics the board of directors’ actual peer group selection process. Specifically, we compare the median peer compensation with the distribution of median compensations for all alternative peer groups that could have been reasonably selected by the board of directors using traditional benchmarks such as firm size and industry. This measure enables us to assess whether the selected peer group produces a CEO compensation benchmark that is at the 1st, 50th, 99th, or any other percentile of the distribution of plausible peer groups. Across our sample of firms, the mean (median) PPP is 74.9 (88.1), which indicates boards of directors generally pick a peer group with higher compensation than the median portfolio of firms they could have reasonably selected. While this descriptive statistic is interesting, the important question is whether this board of director choice reflects inappropriate rent extraction or is an appropriate response to hiring high quality CEOs.

We find that roughly 33% of our observations have a negative relation between PPP and future operating performance. These firms have less talented CEOs and weaker corporate governance than the remaining 67% of observations that appear to select peers to retain and attract executive talent. Firms that appear to select peers for the CEO to extract additional pay earn approximately $5.4 billion in aggregate excess compensation from 2008 to 2014. This amount corresponds to an overpayment of approximately 38% of CEO compensation. Thus, aspirational and rent extraction motivations influence the selection of peer groups for setting CEO compensation, and the economic significance of peer group choice for rent-extracting firms is substantial.

The complete paper is available for download here.

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