Compensation Consultants and the Level, Composition and Complexity of CEO Pay

Kevin J. Murphy is Kenneth L. Trefftzs Chair in Finance and Professor of Finance and Business Economics at USC Marshall School of Business; and Tatiana Sandino is Associate Professor of Business Administration at Harvard Business School. This post is based on their recent article, forthcoming in The Accounting Review. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits by Lucian Bebchuk and Jesse Fried; The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer (discussed on the Forum here); Executive Pensions by Lucian Bebchuk and Robert J. Jackson Jr; and The Growth of Executive Pay by Lucian Bebchuk and Yaniv Grinstein.

Most publicly traded firms retain consultants to provide advice on executive compensation. Prior research documents, based on cross-sectional analyses, that firms retaining executive compensation consultants pay more to their CEOs (a “CEO pay premium”) than firms not using them. Among the subset of firms using executive compensation consultants, research has shown that CEOs are paid more in firms using consultants that provide other services to their client firms (such as benefits management, advice on broad-based compensation plans, etc.). Consultants providing other services could be conflicted, since the CEOs of their client firms could be more likely to offer other services to the consultants that advise their boards to pay them more.

In our study, Compensation Consultants and the Level, Composition and Complexity of CEO Pay, forthcoming in The Accounting Review, we provide new insights on the relation between the use of executive compensation consultants and CEO pay. We analyze data from 2,347 ExecuComp firms from 2006 to 2014 (resulting in over 14,000 US firm-year observations) based on mandated disclosures introduced in 2006 and expanded in 2009 and 2012.

Our analyses confirm that firms using consultants pay more to their CEOs even after controlling for firm time-invariant characteristics and economic and governance determinants. We examine factors explaining this CEO pay premium, beyond the consultants’ provision of other services to client firms.

A textual analysis of proxy disclosures reveals that firms retain consultants to gather advice on: (1) competitive benchmarking information (“benchmarking”), (2) non-equity and equity incentive-based pay (the “composition” of CEO pay), and (3) diverse forms of pay that could be included in the CEOs pay package (the “complexity” of CEO pay). We examine whether benchmarking, CEO pay composition, and CEO pay complexity explain the relation between the use of compensation consultants and CEO pay, above and beyond explanations due to conflicts of interest related to the consultants’ provision of other services. We measure benchmarking based on the number of peers and the extent to which peers deviate from the company’s industry and size; CEO pay composition based on the percentage of CEO pay conveyed in the form of equity and non-equity incentive pay, and CEO pay complexity based on the number of pay components in the CEO pay package (salary, discretionary bonus, the number of non-equity incentive plans, stock options, restricted stock, performance shares, deferred pay, pensions, and other pay) and, alternatively, based on the number of performance measures used in equity and non-equity plans.

Our results show that the CEO pay premium associated with the use of consultants is largely explained by the composition and complexity of CEO pay. The pay packages of CEOs in firms using consultants include greater equity pay and are more complex (i.e., they include a larger number of pay components and more performance measures in incentive plans) than the packages in firms not using consultants. We find no evidence that the CEO pay premium is explained by the consultants’ advice on benchmarking. Composition and complexity fully explain the CEO pay premium associated with consultants not providing other services, but do not explain away the incremental premium associated with the use of (conflicted) consultants providing other services. Our results showing that the CEO pay premium associated with consultants is related to greater use of equity pay and pay components may be due to an increase in risk of the compensation package (and hence, in the pay premium demanded by CEOs). Yet, we find that, on average, firms introducing equity incentive grants layer them on top of existing compensation (in a way that is not explained by the firms’ performance or other conditions), suggesting that risk does not fully explain the additional compensation. This “layering” further increases the impact that CEO pay composition and complexity have on the CEO pay premium. We also find that these relations are nuanced, with causality plausibly running in both directions. Specifically, among firms not using consultants, those offering more generous and complex CEO pay packages are more likely to hire a consultant in the following year.

Our final analyses examine whether the use of executive pay consultants is associated with the shareholders’ “Say-on-Pay” voting outcomes, and find that such shareholders view the role of non-conflicted consultants positively: we find more favorable votes in firms using non-conflicted consultants (but no effect on firms using conflicted consultants) and in firms offering their CEOs more complex pay packages. Additionally, shareholders seem to show no concern when firms add new components to the CEO’s pay packages, even when those components are often layered on top of existing pay.

Our study is the first to show that the positive association between the use of executive compensation consultants and CEO pay, previously documented in cross-sectional analyses, is robust to firm-fixed effects over time and is largely explained by the composition and complexity of the pay package. To our knowledge, this study is also the first to explore the role of the pay levels, pay composition, pay complexity, and benchmarking in a firm’s decision to hire pay consultants, and to examine how consultant use, as well as the components explaining the CEO pay premium associated with consultants (composition and complexity), relate to Say-on-Pay votes.

The complete article is available for download here.

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