Relative Performance Benchmarks: Do Boards Follow the Informativeness Principle?
50 Pages Posted: 12 Jul 2016 Last revised: 15 Feb 2018
Date Written: February 13, 2018
Relative total shareholder return (rTSR) is increasingly used to incentivize and evaluate managers. Although compensation experts acknowledge a primary objective is to filter shocks unrelated to managerial performance, we document that a significant subset of firms, who choose index-based rTSR-benchmarks in lieu of specific peers, do not adequately achieve this objective. Structural estimates reveal that noisy-benchmark selection implies significant negative performance consequences. Reduced-form analysis shows that a firm's choice of index-based benchmarking is 1) driven by its compensation consultants' systematic tendencies and governance-related frictions, and 2) associated with lower ROA, suggesting noisy-benchmark selection is a novel indicator of weak governance.
Keywords: Empirical contract theory; executive compensation; relative TSR; common shock filtration; search-based peers; board of directors; corporate governance; compensation consultants
JEL Classification: G30, M12, M52
Suggested Citation: Suggested Citation