Ramin Talaie/Bloomberg News
furor erupted over the company peer group chosen to figure a $140
million payday for Richard Grasso of the N.Y.S.E.
Now, there are good reasons for rewarding top executives. The decisions
they make are so crucial to their companies that the priority should be
to hire competent people rather than scrimp on pay.
But a study released last week pretty much drives a stake through that
old “pay ’em or lose ’em” line — what you might call the brain-drain
defense. It also debunks the idea that companies must keep up with the
Joneses by constantly comparing their executives’ compensation with that
of similar companies.
This peer-group benchmark — how
executive pay at one company stacks up against pay at another — is a
big driver of ever-rising compensation. Boards say it helps them set pay
based on what the market will bear.
Well, maybe not.
by Charles M. Elson, director of the
John L. Weinberg Center for Corporate Governance at the
University of Delaware, and Craig K. Ferrere, one of its Edgar S.
Woolard fellows, begins by attacking this conventional wisdom. Mr. Elson
and Mr. Ferrere conclude, contrary to the prevailing line, that chief
executives can’t readily transfer their skills from one company to
another. In other words, the argument that C.E.O.’s will leave if they
aren’t compensated well, perhaps even lavishly, is bogus. Using the
peer-group benchmark only pushes pay up and up.
“It’s a false paradox,” Mr. Elson said in an interview last week. “The
peer group is based on the theory of transferability of talent. But we
found that C.E.O. skills are very firm-specific. C.E.O.’s don’t move
very often, but when they do, they’re flops.”
Executive pay has come under scrutiny — and criticism — in recent years,
in part because so many ordinary Americans are struggling in a difficult
economy. Companies have pushed back, often pointing to the peer-group
benchmark. But that benchmark has had a pronounced effect on pay levels
across corporate America. As the Delaware study notes, one company’s
showering of rewards on its executives affects executive pay at every
one of its peers.
In annual proxy statements, compensation committees of corporate boards
tell shareholders which companies they placed in their peer groups and
why. Last year, for example, I.B.M. said it began by including all
companies in the technology industry with annual revenue of more than
$15 billion. But it also added companies in other industries with
revenue of at least $40 billion and “a global complexity similar to
I.B.M.,” the company said. The result was that 28 companies were in the
group, including AT&T, Ford and Pfizer.
Peer groups have come under attack periodically, especially when
they appear to inflate pay.
In 2003, a firestorm erupted over the peer group chosen by the board of
the New York Stock Exchange to compute a $140 million payday for Richard
A. Grasso, its former chairman. Even though the Big Board was then a
nonprofit organization, the board’s peer group included highly
profitable investment banks and huge financial institutions.
Benchmarking against companies that are much larger and more complex has
the effect of increasing pay, experts say.
But even when peer groups are compiled prudently, the Delaware study
contends, they are deeply flawed measures. “Whether the excess
compensation is awarded for merit or otherwise,” the authors wrote, “a
talented individual who is paid on a scale deserving of their abilities
should not, through the peer group mechanism, be allowed to bolster the
pay of less able executives.”
Importantly, the study disputes the notion that executive pay today is a
result of an efficient bidding process for finding and retaining a
scarce and valuable commodity: managerial talent. “In essence, this
process creates a model of a competitive market for executives where it
otherwise does not exist,” the authors wrote. “Through the operation of
a market, it is argued, wages are bid up to an executive’s outside
But there is little evidence, according to Mr. Elson and Mr. Ferrere,
that a hot market exists for interchangeable chief executives. First,
they note numerous academic studies indicating that C.E.O.’s selected
from within a company perform better than outsiders, especially in the
creation of long-term shareholder value.
“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,” the authors
conclude. “In short, executive skills cannot pass the most basic test of
TO be sure, this flies in the face of the widely held view that skilled
managers have become generalists and are therefore far more
interchangeable than in previous years. Proponents of this thesis argue
that top managers today can accumulate a broad knowledge of economics,
finance and management science, giving them the ability to manage any
type of company effectively. Technological advancements also give chief
executives access to untold amounts of data about a particular company
that in previous times would have taken years to amass and synthesize,
this view holds.
But the data on actual C.E.O. moves raises questions about just how
portable C.E.O. skills really are. The Delaware paper cites several
studies indicating that relatively few chief executives land new top
jobs elsewhere. One study, a 2011 analysis of roughly 1,800 C.E.O.
successions from 1993 to 2005, found that less than 2 percent had been
public-company chief executives before their new jobs.
“It appears that the threat to go elsewhere is muted for a sitting
C.E.O.,” the authors concluded. “Particularly for the large firms
comprising the S.& P. 500, C.E.O.’s are rarely traded in any market for
Nevertheless, the notion persists that chief executives and their skills
are transferable — and that they will walk if their pay doesn’t keep
This, Mr. Elson and Mr. Ferrere argue, has given rise to a new type of
captured corporate director. “Rather than being beholden to management
and thus ineffective in negotiating pay because of a lack of
arm’s-length bargaining, boards are now often seen as captive to the
market,” the two wrote.
Because that market is largely based upon the questionable use of peer
groups, the authors contend that those interested in changing executive
pay practices should begin by junking these benchmarks. “Instead,” the
authors said, “the independent and shareholder-conscious compensation
committee must develop internally consistent standards of pay based on
the individual nature of the organization concerned, its particular
competitive environment and its internal dynamics.”
Directors may not like the extra work. Shareholders should insist on it.
“Everyone wants a formula and peer grouping is part of that,” said Jon
Lukomnik, executive director at the
Investor Responsibility Research Center Institute, which financed
the Delaware study. “We need objective measures but we also need to
understand their limitations.”