Market Forces Underlie Benchmarking Trends in CEO Compensation, Shows A. Albuquerque
New Study on CEO Compensation Is First to Provide Evidence that Firms Benchmark High for Market, not Self-Serving Reasons
A new study by Ana M. Albuquerque, Gus De Franco, and Rodrigo S. Verdi is the first to provide evidence that the “peer pay effect” (the tendency to benchmark to a set of peers with higher CEO pay) among corporate boards represents a reward for CEO talent, not self-serving motives or weak corporate governance.
Albuquerque is an assistant professor of accounting at Boston University School of Management. De Franco and Verdi are on the faculty of the Rotman School of Management at University of Toronto and MIT Sloan School of Management, respectively. Their new study, entitled “Peer Choice in CEO Compensation,” is forthcoming in the Journal of Financial Economics.
This paper offers data showing that when firms benchmark high against their peer group in order to offer higher total compensation to their incoming chief executive officers (called the “peer pay effect”), they 1) do so as a reward for CEO talent and not for self-serving reasons, and 2) tend to yield a better future return on investment (ROI) in terms of CEO performance. Thus, the research offers an argument against claims that firms benchmark high among their peers in order to justify flawed corporate compensation packages with excessive CEO pay.
Albuquerque et al use data from ExecuComp, including mostly firms that comprise the Standard and Poor’s 1500 index, for the fiscal years 2006 to 2008, focusing on Definitive Proxy Statements and their Compensation Discussion and Analysis sections which list peer companies used for benchmarking purposes. They define CEO talent by measuring data about a CEO’s historical abnormal stock and accounting performance, the market value of the firms that the CEO managed in the past, and the number of media mentions a CEO has accrued.
In contrast, they define self-serving behavior or poor oversight on the part of boards based on data about board structure (e.g., how busy are board members and thus how much time can they devote to effective oversight and monitoring?) anti-takeover provisions (e.g., how insular is the firm from the external market, which carries the potential threat of a takeover, and thus works as a strong external force for disciplining management?), and ownership concentration (e.g., how personally invested are individual board members in the firm’s future performance?).
Finally, the authors define future ROI as future accounting and stock performance.
From their data pool, the authors find that:
- the impact of benchmarking against highly paid peers for self-serving reasons on CEO compensation is positive in some, but not all, cases, and at a much lower magnitudes than for talent reasons;
- in terms of economic significance, the impact of the peer pay effect for talent reasons on CEO pay is from two to almost ten times larger than is the impact of the self-serving component of the peer pay effect; and, perhaps most crucially,
- firms that benchmark high to offer higher CEO compensation to more talented CEOs yield a better future ROI performance.
Thus, “Peer Choice in CEO Compensation” is an important contribution to the argument that high CEO compensation is crucial to attract top talent as well as to better motivate high-potential CEOs compared to their similarly-high-potential peers who end up with lower compensation due to more moderate benchmarking at their respective firms.
Ultimately, this new research provides evidence that firms who benchmark high do so not simply for self-serving reasons or to justify higher-than-needed CEO compensation, but because they understand the importance of offering a CEO package at the top end of their peer pool, in order to attract, retain, and motivate the best talent.