The majority of companies target their executive pay levels and stock grants toward the median of their carefully selected peer groups. The authors highlight a new dimension for determining peers by using compensation peer information obtained from firms’ SEC filings and investigate whether relative peer quality can affect firm performance.
How Is This Research Useful to Practitioners?
The enhanced executive compensation disclosures mandated by the US SEC in 2006 have provided a significant new dataset for investors and companies to analyze and benchmark pay practices. Since then, total CEO compensation has increased by a significant amount across all industries. The remuneration of many CEOs is not commensurate with performance, which has led to higher risk related to both executive retention and firm performance. With compensation benchmarking a growing concern, there is increasing pressure to analyze related patterns to ensure that best practices are maintained.
Using the findings of prior studies on peer quality, the authors form a peer-quality index and then conduct a regression analysis to assess its impact on firm performance. Controlling for various firm and CEO characteristics, they find that a 1% change in the compensation peer (i.e., peers to determine a CEO’s overall compensation) index gives a 0.6% increase in a firm’s return on assets. The effect of bonus peers (i.e., peers to determine a CEO’s relative-performance-based bonus) on firm performance is inconclusive because of insufficient data. However, bonus peers’ quality also affects firm performance. The authors find that a firm with low growth potential can motivate its executives by using a relatively high-quality peer. They also find that firms with high relative peer quality (RPQ) have more independent directors and a greater percentage of institutional ownership than do low-RPQ firms.
How Did the Authors Conduct This Research?
The sample set is taken from S&P 1500 firms, comprising 3,694 firm-years, that report their compensation peers over 2006–2010. Only 15% of firms with compensation peer data report bonus peer data. The managerial ability scores for these firm-years are obtained from Compustat and CRSP, yielding data on each firm’s mean number of peers, whose other firm characteristics are compared with those of the reporting firms.
To measure the managerial quality of each firm and its peers, the authors use the Demerjian, Lev, and McVay (Management Science 2012) measure and then rank each firm in its peer group to determine its RPQ index, with index values ranging from 0 (lowest managerial score) to 1 (highest managerial score). The firms are categorized as high RPQ or low RPQ to draw implications from the analysis. To determine the significance of RPQ in firm performance, they regress characteristic-adjusted stock returns and adjusted returns on assets based on RPQ while controlling for many financial, CEO, and corporate governance characteristics. In addition, the authors perform robustness checks on the model, which is subject to endogeneity concerns. They also draw implications about the relationship between RPQ and risk-taking behavior and between RPQ and earnings management.
Abstractor’s Viewpoint
If common exogenous shocks affect the performance of multiple agents, economic theory predicts that an incentive compensation scheme based on relative performance is superior to one based on individual performance when the agent is sufficiently risk averse and/or the common uncertainty is high. Relative performance evaluation can improve incentive contracting by providing incentives for executives to outperform their competitors. The evidence gathered from similar studies in different regions suggests the same conclusion.
Only a few of today’s popular approaches genuinely align senior executives’ pay with the economic value they create. Wage packets of FTSE 350 chief executives have risen 82% over the last 13 years while returns on money invested have been 1%, according to CFA Society United Kingdom. Measures typically used by companies to calculate performance (e.g., total shareholder return and earnings-per-share growth) place too much emphasis on short-term results. The RPQ index created by the authors does a good job of analyzing the impact of compensation peers and, to some extent, bonus peers on firm performance, despite the lack of available data for determining bonus pay.