This has exacerbated the long-term trend of top corporate officials increasing the pay gap between themselves and the rest of society. CEOs in the Standard & Poor's 500 saw the gap between their compensation and salaries paid to their workforce increase 20% between 2009 and 2011, when chief executives received 204 times more than the average worker, according to a Bloomberg analysis.
The use of peer groups by board compensation committees in determining CEO pay has played a major role in driving those salaries upward, critics contend. Ira Kay, a compensation consultant and proponent of their use, says executives operate in a competitive market for top talent and incentives such as stock options, bonuses and generous retirement packages have successfully retained highly mobile executives.
Kay, a managing partner with consultant Pay Governance, says the contention that CEO compensation is too high isn't one that can be addressed by attacking the use of peer groups, which merely reflect the market. “That's not a peer group problem, that's a social problem,” he says.
Financial reforms enacted in the wake of the 2008 financial crisis sought to give shareholders a voice—though not the authority—to curb rising executive compensation. Ferrere and Elson argue in their 2012 paper that that will not be enough to overcome the more systemic flaws in compensation policies that rely on peer groups to determine compensation.
Stellar performance—and compensation to match—for a few standout executives within a peer group skew the compensation comparisons, they argue. That unfairly rewards more average or lackluster CEOs as boards seek to match the rising compensation at other firms, which sometimes aren't even in the same industry.
It can become a vicious circle. As governing boards of directors or trustees award raises to match the median pay at other firms, the other boards respond in kind, they wrote. Boards often feel pressure to award compensation at or above the median as a public endorsement of CEO performance, they wrote.
Some firms are clearly sensitive to the issue. UnitedHealth Group, the nation's largest health insurer, last month assured shareholders that the below-median compensation for President and CEO Stephen Hemsley was not a reflection of his performance. The company's directors praised Hemsley's leadership as “outstanding” in the insurers' annual proxy to investors even as it noted his roughly $13.9 million package of cash, incentives, equity awards and other payouts was “well below” the median for peers at a diverse group of companies, including eBay, Citigroup, Coca-Cola and a few managed-care giants.
The broad group by which UnitedHealth compares CEO pay was vetted to exclude industries that would be unlikely as a source of new recruits, such aerospace, oil and companies that focus exclusively on one business line, the proxy says. The group reflects the insurers' size and complexity, the company continued, and also takes into account potential competitors for top executives that operate in the same geographic location as UnitedHealth's management. Hemsley, the company says, believes the pay package “is sufficient to retain and motivate him.”
Kay of Pay Performance contends critics' inflation argument is “overstated” and points to data that show executive compensation rises and falls with stock performance.
Ferrere and Elson argue that top executives are not so easily swapped because the detailed knowledge of their own company needed to run the business has no value elsewhere. That weakens the argument that compensation must be comparable to prevent executives from bolting for another, more lucrative job.
Good governing boards are sensitive to the dynamic created by peer groups that can inflate compensation, says Ron Seifert, vice president and leader of executive compensation at the Hay Group.
The question of how much to pay is not solely answered by blindly matching every move the market makes, he says. Boards that have grown more sophisticated may also refer to compensation awarded among its own executives and the potential value of payouts based on a range of stock prices as they consider how much to pay. Compensation is also influenced by performance goals tied to incentive payouts and how those incentives are structured, he says.
At publicly traded companies, outside shareholder advisory services are looking closely at the composition of peer groups. For instance, Institutional Shareholder Services criticized Community Health Systems' peer groups ahead of last year's vote as “aspirational” and described Chairman, president and CEO Wayne Smith's pay as “considerably higher” than the median of his peer group and tied to “seemingly unchallenging performance goals.”
Institutional Shareholder Services and proxy adviser Glass Lewis urged shareholders to vote down the 2012 compensation package. They did. CHS last month said the board revised its peer group after two-thirds of shareholders rejected the health system's 2012 executive compensation in an advisory vote.