The right peer group for the right pay plan: guiding principles for formulating a peer set that will withstand heightened scrutiny and promote rational pay decision making.

• Author: Olsen, Scott N.
• Position: COMPENSATION COMMITTEE - Company overview

MANY JOURNALISTS and compensation experts have written articles that lament rapidly increasing executive pay over the past few years. Some authors have cited faulty peer group development as one of the underlying causes. Peer groups, they imply, may have been created poorly by accident or perhaps without the use of expert assistance. They also indicate that there may be more overt factors behind some faulty peer groups, such as consultants that are advocates for executives or management that cherry-picks high-paying peers.

Given heightened scrutiny by investors and greater exposure of executive pay decisions due to new proxy disclosure rules, it is in the best interest of your company to develop an appropriate and durable set of peers that can withstand this scrutiny. Equally important, a relevant and well-crafted peer set will assist your company in making rational pay decisions.

To this end, we have provided our set of guiding principles--and one critical rule--for evaluating potential peer companies.

Guiding Principle 1: Relative peer company scope should be reasonable

Since there is a proven correlation between organization size and executive pay, common scope measures such as revenue, assets, market capitalization, and number of employees should be evaluated for each peer company to ensure that they fall within some reasonable range of current/anticipated size.

We typically recommend the use of one or more of these scope measures based on the industry in which a company operates--service companies may focus more on employees and revenues, financial services more on assets and market cap, etc. In reviewing size, we typically use one-half to two times a company's size as a guide to whether a company should be included in the peer group. However, the range for these metrics may vary depending on the size of the desired peer group and availability of relevant peer companies.

Guiding Principle 2: Industry focus and operational profile should reflect your business

Does the potential peer sit within the same industry? Does it operate in a similar manner to your business? Companies should review peer companies in their sector/SIC code/industry, however they wish to define it. Guiding Principle 2 uses a second screen--operational profile--as a filter for selecting potential peer companies.

Consider two companies in, for example, the cold storage industry. One operates cold storage warehouse space and provides supply chain solutions for grocery...