Blind Peer Grouping Creates Pay Spiral

It’s time for Boards to stop worrying their CEO is going to be poached by other companies who pay more, according to a new paper from the John Weinberg Center for Corporate Governance at the University of Delaware in the US.

The paper, published by Center director Charles M.Elson and Research Fellow Craig Ferrere has pointed to a “blind reliance” on peer group benchmarking, saying it has created a steady increase in the level of CEO pay and, despite arguments to the contrary, does not reflect an efficient market for talented executives.

The research argues that since companies rarely, if ever, decide to target remuneration below the median pay for their market capitalisation range, it is inevitable that there is an upward bias in the amount that executives are paid over time. It has been this upward bias that has created a significant disparity between the pay of US executives and what the authors of the paper believed appropriate for the companies the executives run.

The effect of peer group benchmarking has been further exacerbated by a tendency to exclude certain companies from peer groups that would lead to an unfavourable remuneration outcome for the executive, and the pay of certain high flyer CEOs who skew the numbers upward.

The authors argued that benchmarking leads to a remuneration scheme that does not pay for performance. If an executive is paid more because they are both talented and effective, peer group benchmarking sees that pay increase push up the salary of other mediocre executives operating in companies of the same size. Because of this, pay doesn’t depend on performance, but on one variable: size of company.

Companies will argue that they need to make sure they are paying the market rate, or their executives will be poached. Yet, the irony is, the companies that poach executives in that manner will generally experience worse performance than they would have received from an executive they promoted through the ranks, according to the paper.

It argued that, contrary to popular opinion, general management skills were not the key to a CEO’s success, but rather a CEO needed to understand the company’s specific business in depth. It quoted research stating that companies often suffered poor results after bringing in a well performing CEO from another company, unless that CEO had been brought in for specific skills; for example, experience in restructuring a company or conducting mergers and acquisitions.

This, it postulated, took away one of the key tenets of the argument for paying based on peer group benchmarking — executives were a group of highly mobile professionals that needed to be retained. In fact, the paper stated, their skills are not overly transferable.

“There is no conclusive empirical evidence that outside succession leads to more favorable corporate performance, or even that good performance at one company can accurately predict success at another.”

It also stated that CEOs weren’t particularly mobile and would generally only jump if the company they were moving to was significantly larger than their last. Since it was unlikely that the small company would be able to outpay the larger, this made the peer group irrelevant, the paper argued.

“The universal application of the peer grouping process has likely dictated the observed reality by unjustifiably injecting the notion of rigorous external markets into negotiations, where in fact, they do not exist.”

Since executive pay has a cascading effect on the pay for employees throughout the company, this trend has also affected other company employees profoundly. In some cases, employees were paid more to reflect the changing internal relativity, while in other cases, an inequity in pay arose, which de-motivates employees and can provide incentives for misbehaviour.

Although Australia is generally considered to be a much more moderate market where pay is more in line with company performance, we have seen a similar trend for burgeoning executive pay.

The paper believed companies needed to stop using peer benchmarking exclusively to set executive pay, and instead set internal remuneration policies which encourage appointment from within, leading to internally promoted CEOs receiving pay that was more than their previous role, but not to the level of what an external candidate may have received.

At Egan Associates, we consider data from benchmarking, while important in scanning the parameters of reward, to be only one element in a multitude of factors that need to be considered when setting pay. In addition to market expectations, other filters would include revenue, assets, profitability, geographic diversity, industry sector and the size and nature of the workforce. Given the considerable current variability in company performance, boards may need to consider new work value tools that assess how much the performance of the leadership team is worth, having regard to the company’s strategic imperatives and its requirement of attracting and retaining appropriate talent.

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