Woon Sau Leung is Professor of Finance at the University of Southampton Business School. This post is based on a working paper by Professor Iftekhar Hasan, Professor Leung, and Dr. Stefano Manfredonia.
Academics have long been interested in understanding whether pay packages for CEOs are efficiently designed. Research under the “efficient contracting” view believes high pay reflects a premium for managerial talents, human capital, and/or other non-monetary benefits. On the other hand, another strand of the literature argues that the pay-setting process is inefficient, as CEOs can extract rent by exercising their power over the board of directors and driving pay up.
Increasing attention has been paid recently to compensation consultants and their role in the ever-rising CEO pay. Most large corporations today employ compensation consultants who offer a range of services to their clients, including compensation structuring, incentives, actuarial analysis, and human resources support. Many believe that these consultants can contribute to making CEO pay settings more efficient due to their industry expertise and informational advantages. However, some acknowledge that consultants may have an incentive to secure new or repeat business and cross-sell other services. Such conflicted interests may lead them to favor incumbent management and be overly generous in their pay recommendations.
In addition, another recent line of research argues that the widespread use of “peer groups” to benchmark CEO pay contributes to CEO pay inflation. In essence, this benchmarking practice compares and aligns the CEO’s pay within a firm with the median or higher percentile pay among its compensation peers. While pay set using this method may better reflect managerial outside options, managers often have the power to influence the selection of pay peers. Empirical evidence indicates that firms tend to select compensation peers with higher-paid CEOs, a phenomenon known as the “peer pay effect,” which introduces an upward bias to CEO pay.
In our paper, we bridge the two strands of literature and investigate the influence of consultants on the selection of CEO pay peers. Furthermore, we also examine whether such influence, if any, affects overall CEO compensation.
Consultants are the main source of pay-related information for firms for three reasons. First, consultants are experts in information acquisition and are knowledgeable about the relevant laws and pay practices in the market. Second, consultants have access to proprietary pay-related information due to client advisory relationships. Third, consultants face lower information costs as information acquired can be shared among their clients. As such, consultants have control over what and how much pay-related information of potential peer firms to provide to clients, which can affect the latter’s peer selection should they want to. Moreover, consultants with conflicted interests can selectively provide and withhold information on certain peers and use such discretion to induce clients to favor peers with higher-paid CEOs.
To test our hypotheses, we collect data on 194 consultants retained by 1,075 U.S. publicly listed firms from the Institutional Shareholder Services (ISS) Incentive Lab database over the 2006-2019 period. On average, a firm in our sample has 18.9 CEO pay peers. In over 86% of our sample, firms contract at least one compensation consultant.
To establish a link between consultants and pay peer groups, our first test examines whether changes in the composition of the pay peer groups occur mostly when new consultants are appointed. Our data supports this conjecture.
Next, we estimate peer-choice models to provide more direct evidence of consultants’ influence on the selection of pay peers. Specifically, we test whether firms are more likely to select potential peers who employ the same compensation consultant. The premise is that consultants likely face resource constraints and are thus incentivized to offer less costly services. Because the search for accurate market information on compensation policies often requires considerable resources, time, and effort, consultants would be better off if their clients select peer firms where the cost of information acquisition is low, such as those with which they are familiar due to existing business relationships, i.e., a familiarity bias.
Our results are in line with this prediction: the probability of a potential peer firm being selected is 49.3% higher if it employs the same consultant. The peer pay effect is also significantly larger for those firm-peer pairs where the same consultant is employed. Overall, the evidence is consistent with the view that consultants have a non-trivial role in firms’ pay peer selection and respond to conflicted interests, which leads to inflated CEO pay.
We perform additional tests at the firm level to test whether the consultants’ influence over peer selection affects CEO pay. More specifically, our mediation tests show that firms with a higher proportion of peers sharing the same consultant are associated with higher peer-median CEO pay, which translates into higher CEO pay. Such firms also have CEO pay that is less sensitive to performance, and they are less likely to terminate their incumbent consultants. Collectively, the evidence suggests that consultants respond to conflicted interests, favor incumbent management, and inflate their CEO pay by influencing firms’ selection of pay peers.
Our study offers new evidence to the ongoing debate on whether compensation consultants should be held accountable for the persistent increase in CEO pay over the years. Building upon two separate strands of compensation literature, our findings suggest a novel channel through which compensation consultants impede efficiency in the pay-setting process.
The full paper is available for download here.