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.
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
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.