Like Lake Wobegon, Garrison Keillor's fictitious Minnesota town where all the children are above average, executive compensation practices often assume that corporate managers are equally superlative. When shareholders question lush pay, they are invariably met with a laundry list of reasons that businesses use to justify such packages. Among that data, no item is more crucial than the "peer group," a collection of companies that corporations measure themselves against when calculating compensation.
But according to a handful of pay experts who are privy to the design of pay practices at the nation's largest corporations, many of these peer groups are populated with companies that are anything but comparable. They also say corporate managers themselves - who have an interest in higher pay - are selecting which companies make it into a peer group. And because these companies are often inappropriate for comparison purposes, their use has helped inflate executive pay in recent years.
"The peer group is the bedrock of the compensation philosophy at a company," said James F. Reda, an independent compensation consultant in New York. "But a lot of people do it by the seat of their pants, and that is part of the reason why executive pay has really skyrocketed."
The use of peer groups to calculate executive pay has become ubiquitous in recent years. This is partly in response to the Securities and Exchange Commission's requirement that companies compare their stock performance with a peer group in tables in the section of their proxy filings devoted to shareholder returns. Theoretically, these tables allow investors to compare their company's performance against objective benchmarks.
But as is true with much about executive pay, details about exactly how peer groups are compiled have been kept under wraps. The worry among investors, of course, is that executives, consultants and directors simply cherry-pick peer-group members, thereby pumping up pay packages.
Current disclosure rules require neither the identification of companies in a compensation-related peer group nor the rationale behind their selection. Usually, the most a shareholder learns about companies in a compensation peer group is that they are in the same industry or of a similar size.
New SEC rules
This ambiguity will change when new SEC disclosure rules go into effect Dec. 15. The rules will require a corporation to reveal which companies it uses in its peer group and to provide an extensive description of its compensation philosophy.
Under the new rules, company officials will also have to certify the accuracy of their pay disclosures. As a result, peer groups are likely to attract increased scrutiny, said Mark Van Clieaf, managing director of MVC Associates International, a consulting firm that specializes in organization design and pay-for-performance standards.
"Is benchmarking pay across companies truly comparing apples to apples?" Van Clieaf asked. "Failure to have a legally defensible process" can lead to "materially false" disclosures, he said.
Compensation experts note that when a majority of companies in any given industry are in the 75th compensation percentile, pay packages may be subject to the Lake Wobegon effect: that all chief executives are suddenly above average.
Corporate directors argue that comparing pay practices with those of competitors is only fitting, given that those are the companies they usually look to when recruiting employees and executives. But pay critics contend that an unquestioning reliance on the use of such peer groups is too simplistic and contributes to a one-size-fits-all mentality in pay.
"Sometimes it doesn't matter what the other guy is doing," said Brian Foley, an independent pay consultant in White Plains, N.Y. "First and foremost, is what makes sense for this company. If you're in a turnaround and you are comparing yourself to guys who never had a dip and are quite successful, it's a question not just of comparison based on size but also based on circumstances. I think these questions are asked sometimes, but sometimes they seem to be glossed over."
Van Clieaf said the composition of peer groups is usually more heavily weighted to larger companies, even though corporations typically look to smaller companies when recruiting top executives. This reality calls into question the oft-heard argument that out-sized pay is based on market forces and that because companies have to jockey for the very best, enormous compensation deals are reasonable.
"Where would you really go to look for talent," Van Clieaf asked. "Either at the second or third layer down at bigger companies or the No. 1 role at smaller companies. Do you really think the CEO of Johnson & Johnson is going to go to work at Eli Lilly?"