Opinion

Executive compensation: the importance of ‘peerage’?

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Print this page by Robert L. Musick Jr. and Richard Deutsch

We have often noted that the selection of a peer group is the critical first step for purposes of assessing competitive compensation for executives.  We also emphasize that peer data is informative but not necessarily determinative in setting executive compensation.  A recent article in the Washington Post raises important (and awkward) questions about the use of peer analysis.

The Amgen example  

Although other cases are cited, the article focuses on the compensation of the CEO of Amgen, a large, publicly-traded bio-tech company.  Why would the compensation committee reward the CEO of a company that had lost 3 percent of its value in 2010 (7 percent over the last five years) and shed 2,700 jobs with a 37 percent increase in compensation (to $21 million)?  Good question!
According to the Post, “Amgen selected 11 companies in the biotech/pharmaceutical field [as a peer group for comparison], which seems natural enough. But most of the companies on the list are far larger than Amgen. Amgen’s revenue in 2010 was $15 billion; the median revenue of its peer companies was $40 billion, according to Equilar.

Also, the compensation committee agreed to pay the CEO more than most chief executives in the industry, targeting a compensation “value closer to the 75th percentile of the peer group.”

Peer selection

Of course, the idea behind setting executive pay this way, known as “peer benchmarking,” is to keep talented executives from leaving.  The practice of choosing peers that boost pay is not uncommon. Several studies have shown that when choosing peers for pay-setting purposes, companies tend to choose larger firms or firms with more highly paid chief executives.
Particularly troublesome is the fact that a chief executive’s pay is more influenced by what his or her “peers” earn than by the company’s recent performance for shareholders, according to two independent research efforts based on the new disclosures. “Peer benchmarking has a significant influence on CEO pay,” one researcher noted. “Basically, you can’t have every CEO paid above average without pay ratcheting upward over time.”

‘Everyone is doing it’

According to the Post, “… the practice has long been controversial because, as critics have pointed out, if every company tries to keep up with or exceed the median pay for executives, executive compensation will spiral upward, regardless of performance. Few if any corporate boards consider their executive teams to be below average, so the result has become known as the “Lake Wobegon” effect.”

It wasn’t until recently, however, that its pervasiveness and impact on executive pay became clear.  Since 2006 (when the SEC required more detailed disclosure), researchers have found that about 90 percent of major U.S. companies expressly set their executive pay targets at or above the median of their peer group.

Even before the extent of the practice was known, it drew criticism from prominent business figures. After the Enron scandals, a blue-ribbon committee led by Peter G. Peterson, then chairman of the Federal Reserve Bank of New York, and John Snow, former chairman of the Business Roundtable, called for setting executive pay “unconstrained by median compensation statistics.” Legendary investor Warren Buffett, in one of his famously plain-spoken letters to investors, likewise derided the method.  “Outlandish ‘goodies’ are showered upon CEOs simply because of a corporate version of the argument we all used when children: ‘But, Mom, all the other kids have one,’” he wrote.  Similarly, former Federal Reserve Chairman Paul Volcker called it the “Lake Wobegon syndrome” in congressional testimony in 2008, referring to Garrison Keillor’s fictional town where “all the children are above average.”

The practice has persisted because many corporate board members have personal or business relationships with the chief executive.  These kinds of ties between chief executives and the boards that oversee them are common in corporate America. On a typical board, the chief executive considers about 33 percent of the board of directors as “friends” rather than as mere “acquaintances,” according to a survey of chief executives at about 350 S&P 1500 corporations conducted over 15 years by the University of Michigan.  More pointedly, the chief executive is likely to find even more friends on the compensation committees of corporate boards — almost 50 percent.

Conclusion

The Post article draws attention to several problematic issues in Amgen’s executive compensation practices.  However, it is important to note that in May, 56 percent of shareholders approved the company’s executive compensation practices in its “say on pay” vote.

While much of the article sounds like a screed against corporate greed, it touches on some fundamental concepts, in which we fully concur:
• Thoughtful selection of peers is crucial (and, as we have always noted, size matters).
• Targeting the appropriate percentile requires justification, as well as deliberation.
• Performance (both absolute and compared with peers) must weigh more heavily in the process than mere peer pay data.


Robert L. Musick Jr. and Richard Deutsch are principals at the human resources consulting firm The Titan Group in Richmond. They can be reached at bmusick@titanhr.com and rdeutsch@titanhr.com.


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