Peer groups: clear drawbacks, but the jury is still out.

• Author: Larcker, David
• Position: CEO COMPENSATION - Reprint

The compensation committee and the board of directors are responsible for determining the level of compensation paid to the CEO and other officers. They must also select the mix of short-term and long-term elements to achieve a payout structure that is consistent with the firm's strategy In theory, this should be a straightforward exercise, with the level of total compensation set to be commensurate with the value of services received.

The process might work as follows; First, determine how much value the company expects to create during a reasonable time horizon (for example, five years). Then determine how much of this value should be attributable to the efforts of the CEO, Finally, determine what percentage of that value should be fairly offered to the CEO as compensation.

Although many boards may implicitly follow this type of approach, it is exceedingly difficult to measure the value creation attributable to the efforts of a specific executive.

Instead, most boards determine compensation levels by benchmarking their CEO's pay against that of a set of companies that are comparable in size, industry, and geography (peer group). Interviews with compensation consultants reveal that companies commonly aim to provide cash compensation (base salary and annual bonus) at the 50th or lower percentile of the peer group and long-term incentives (primarily equity-based compensation) at the 75th percentile. These figures represent the board's assessment of the market wage opportunity of the CEO and other executive officers. The compensation committee also needs to make sure that the level of pay suggested by the benchmark has a similar level of risk as the compensation packing being considered for the executive.

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Although benchmarking presumably enables a company to remain competitive regarding the level of compensation, it has some obvious drawbacks:

* First, compensation levels might become inflated overtime as companies increase pay to match amounts paid by peers. When multiple companies within a group try to meet or exceed the median, the median itself tends to increase, creating the well-known ratcheting effect.

* Second, benchmarking determines pay without explicit regard to value creation. This might encourage executives to engage in uneconomic behavior, such as acquiring a competitor purely to increase the size of the overall organization, resulting in a shift in...