Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts
Penn State University - Smeal College of Business
Laura Yue Li
University of Illinois at Urbana-Champaign
Jae Yong Shin
Seoul National University - College of Business Administration
November 2, 2010
Accounting Review, Forthcoming
This study examines the explicit use of relative performance evaluation (RPE) in executive compensation contracts and the selection of RPE peers. Using S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules, we find that about 25 percent of our sample firms explicitly use RPE in setting executive compensation. We demonstrate that a lack of knowledge of both actual peer group composition and the link between RPE-based performance targets and future peer performance significantly hinder the traditional implicit test from detecting RPE use. We also find that firms consider both costs and benefits of RPE as an incentive mechanism when deciding to use RPE. Finally, both efficient contracting and rent extraction considerations influence RPE peer selection, with the relative importance of these competing considerations depending on RPE firms’ performance.
Keywords: executive compensation, relative performance evaluation, peer group, SEC regulation
JEL Classification: J33, J44, M41, M52Accepted Paper Series
Date posted: November 3, 2010
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