Relative Performance Benchmarks: Do Boards Follow the Informativeness Principle?
52 Pages Posted: 12 Jul 2016 Last revised: 11 Oct 2018
Date Written: October 4, 2018
We examine whether and to what extent managers are evaluated, in their relative performance contracts, on the basis of systematic performance. Focusing on relative total shareholder returns (rTSR), the predominant metric specified in these contracts and used by market participants to evaluate managers, we document that 60% of firms—those that choose specific peers—do a remarkable job of capturing the systematic component of returns in adherence to the informativeness principle. However, 40% of firms—those that choose index-based benchmarks—retain substantial systematic noise in their rTSR metrics, which they could have substantially corrected by using their self-chosen compensation-benchmarking peers. The selection of noisy benchmarks is economically important, is associated with lower ROA, and can be explained by compensation consultants’ tendencies and firms’ governance weaknesses.
Keywords: Executive compensation; relative performance evaluation; relative TSR; common shock filtration; systematic risk; search-based peers; board of directors; corporate governance; compensation consultants
JEL Classification: G30, J33, M12, M52
Suggested Citation: Suggested Citation