Firms Inflated CEO Pay by as Much as 10 Percent by Benchmarking Compensation Against Top-Paying Companies

Newswise — Explosive growth in CEO pay has led some critics to question whether firms are biased in how they determine executive compensation.

In fact, companies that used compensation peer groups to determine executive pay did artificially inflate such compensation -- but only by approximately 10 percent, according to research from the Indiana University Kelley School of Business.

The study is among the earliest to analyze data resulting from a 2006 Securities and Exchange Commission (SEC) mandate that companies disclose members and benchmarks in compensation peer groups, which compensation committees create to ensure executives are paid at levels that will retain and attract top talent. The research examines firms' first fiscal year ending after the law's compliance date.

Findings show that companies in the Standard & Poor's (S&P) 500 and S&P MidCap 400 justified and increased compensation by benchmarking senior executive pay levels against top-paying competitive peer groups -- usually about 20 companies similar in such things as industry, size, visibility, CEO responsibility and talent flow. This was most prevalent among firms where CEOs chaired the board of directors and had lengthy tenures as chief executives, which enabled them to directly influence their own pay.

"There are two basic schools of thought on this issue: either CEOs are unduly inflating their paychecks or they're 'super talents,' akin to athletes and celebrities, who deserve to be compensated accordingly," says Jun Yang, assistant professor of finance at the Kelley School and co-author of the study.

"Our findings fall somewhere in the middle, demonstrating that while CEOs did seek to influence their pay, the increases they were getting from such efforts are not as much as critics have suggested," she added.

According to Yang, the retroactive nature of the law -- it required firms to reveal data on compensation decisions made before the legislation passed -- offers a rare glimpse of how companies behave when they don't expect to be scrutinized.

"Some critics have expressed surprise that firms and CEOs in particular didn't inflate their pay more, considering they weren't anticipating disclosure," she said. "Today, the practice is likely more honest now that companies know the government is paying attention."

Yang co-authored the study, "Inside the Black Box: The Role and Composition of Compensation Peer Groups" with Michael Faulkender at University of Maryland. It appeared in the May issue of Journal of Financial Economics.