Peer group benchmarking has increasingly become a vital component to executive compensation design because it contextualizes companies’ pay decisions, clarifying why executives are earning what they’re earning. Shareholders often look for detailed pay disclosure that justify and explain pay decisions beyond motivating and retaining key talent. In the last five years, the number of S&P 500 companies disclosing a compensation benchmarking group has increased from 91.2% to 95.4%, evidence that this has become a best practice.
Executive compensation peer groups include companies who compete in a similar corporate landscape, matching in size and focus, and, in turn, attracting similar executives. In order to retain top talent, boards benchmark their executives’ pay packages to these peers so that their pay is competitive and appropriately drives company performance.
Equilar examined S&P 500 companies’ peer groups in their 2016 Peer Group Composition and Benchmarking report, which featured independent commentary from Pay Governance, covering how leading companies design and use their executive compensation peer groups.
Peer group construction revolves around finding a balance between including relevant companies that match in size and focus, and enough companies to make comparisons meaningful. More than two-thirds of S&P 500 companies have peer groups inclusive of 11 to 20 companies, though there is extensive variation with peer group sizes ranging from 2 to 132. These large peer groups often compete in fragmented industries and take a broad industry overview when benchmarking executive compensation.
Besides variations in size, some companies use multiple peer groups when benchmarking different components of their pay packages. These companies often belong to multiple industries or have executives working abroad and they use separate benchmarking groups to address these differences. While this practice is rare—with only 9.9% of companies using two peer groups and 1.1% using three or four—it remains an important practice for addressing complicated benchmarking situations where a single peer group falls short.
“While a minority practice, companies use multiple peer groups for many reasons. For companies with much larger competitors, they may benchmark against those larger companies to assess non-pay related items such as incentive designs,” wrote Patrick Haggerty and Joe Mallin, both partners with Pay Governance. “Another example is for companies that recruit for talent in diverse industries. Since pay models and levels can be very different across industries, it is important to have benchmarking data to support pay decisions.”
While many factors influence peer group selection, companies typically disclose specific criteria that play defining roles in their decisions. Out of the entire study, industry was the most cited criteria for influencing peer group construction, appearing as a factor for 441 S&P 500 companies.
Besides industry, financial comparisons like revenue and market cap were frequently cited criteria, appearing 363 and 308 times respectively. Companies also often chose their peer groups based on companies that compete with them for executive talent, with 328 companies citing this criterion. Selecting criteria reflects what factors companies consider important when determining how they will benchmark their executive pay and these differences may be more pronounced in different industries.
For example, companies who hire management with universal skillsets may be more likely to specify competition for talent as a criterion because they know that these executives could easily transition to a new company.
Many S&P 500 companies look to non-U.S. based competitors when determining executive pay. A majority (52.1%) included only U.S.-based companies in their peer group, while 42.3% of companies named peer groups comprising up to 25% companies based outside the U.S. Just 0.6% of the S&P 500 had a peer group made up of a majority non-U.S. companies.
Low corporate tax rates make Ireland a desirable place for U.S. companies to relocate headquarters—often through inversion mergers—and many of the 183 named S&P 500 peers in Ireland are likely predominantly U.S.-operating outfits. Meanwhile, Great Britain, Canada and Switzerland hosted the next-largest concentrations of S&P 500 peer companies with 136, 86 and 77 references respectively.
“Over the past few years, proxy advisors have played a role in influencing peer group creation and CEO pay comparisons,” noted Haggerty and Mallin. “In evaluating pay for performance alignment, some proxy advisors establish their own peer groups to compare a company’s relative CEO pay and total shareholder return. Since these proxy advisor reports are typically shared with compensation committee members, many companies have adjusted their peer group development approach to be more aligned with proxy advisors.”
To identify how reported pay correlates to peer group construction Equilar juxtaposed the CEO total direct compensation (TDC) of the S&P 500 disclosed proxy peers and found that 53.5% of companies’ TDC fell within the 25th to 74th percentiles of their peer groups. Ultimately, this can mean a lot of things—there may be a very small range within a peer group, for one—but it shows that while targeting the median is a common strategy and a best practice, outcomes can vary and for investors and other stakeholders evaluating CEO pay, there is more to consider than just the raw numbers.
This difference demonstrates variable pay as an important component of executive compensation. Companies will set award targets for their executives that depend on meeting performance goals—exceeding or falling short of these goals is likely to result in a payout above or below peer group median. These “at risk” elements are another explanation for the relatively even distribution of CEO TDC aligning with proxy peers’ compensation (Figure 3). A perfectly targeted and achieved award system would likely result in CEO TDC closer to median levels.
“There are several situations that often result in below-median pay for CEOs versus peer companies,” said Haggerty and Mallin. “We typically find that newly promoted CEOs, who have not been CEOs before, are often paid below well below median with the expectation that they will get to median over a period of years (usually two to five years) depending on performance during that time frame. We believe most companies prefer promoting CEOs from the inside because of the risks often associated with hiring CEOs from the outside and because outside hiring often results in above-median pay programs.”
However, this system is not fool-proof. Opponents of growing executive pay see peer groups as a type of “ratchet” that inflates executive pay package size as pay is compared and increased year after year. For example, a recent study from MSCI, entitled Are CEOs Paid For Performance, found that CEOs in the last 10 years have been compensated above their sector median while delivering below the sector median in total shareholder return. This analysis suggests that companies are increasing pay without necessarily considering executive performance compared to their entire sector, or choosing unnecessarily large peer groups.
Ryan Villard is a research analyst with Equilar. For more information on Equilar’s Peer Group Composition and Benchmarking 2016, featuring commentary from Pay Governance, please visit www.equilar.com/reports.