Executive Superstars, Peer Groups and Overcompensation: Cause, Effect and Solution

Abstract

In setting the pay of their CEOs, boards invariably "benchmark" compensation to either the 50th, 75th, or 90th percentile of what similar companies pay. Although the process is said to pinpoint a “market wage” necessary for executive retention, the idea of a competitive market was created purely by happenstance and is based on flawed assumptions about the easy transferability of executive talent.

It has been observed that through the practice of targeting the pay of executives to the benchmark median, or higher, pay is necessarily driven upward. In the long-run, this effect has caused a significant disparity between CEO pay and what would actually be best at the companies they run. This is not surprising as pay based on external comparisons is untethered from the actual wage structures of the rest of the organization.

There are significant costs, we argue, to runaway CEO pay because the pay at the top affects incentive structures down through the corporate hierarchy. To mitigate this, boards must target consistency with the internal corporate wage structures more than external benchmarking.

The solution to the pay problem lies in avoiding the mechanistic and arbitrary application of peer group data in arriving at executive compensation levels. The way out is for independent and shareholder-conscious compensation committees to develop standards based on the individual nature of the organization concerned, its particular competitive environment and its internal dynamics.

Keywords: Executive Compensation, Peer Groups, Peer Benchmarking