Peer pressures

As chief executive pay continues to draw heightened scrutiny in the wake of the Great Recession, compensation comparisons used by governing boards to justify the payouts to shareholders and regulators are coming under fire from critics.

The practice, common in the healthcare sector, has drawn fire for years. Critics claim reliance on peer group analysis is flawed and artificially inflates salaries and bonuses.

Their complaints are beginning to be heard, including by the healthcare sector. One of the largest publicly traded health systems has revised its executive compensation peer group, which considers the market in which companies must compete on pay to recruit and retain top talent.

The Internal Revenue Service also is beginning to examine CEO pay at big not-for-profits, which are the dominant players in much of healthcare. An IRS examination released last month found one out of five tax-exempt organizations used comparisons from institutions that were so different in size or other characteristics that regulators deemed them “not comparable.” The incompatible compensation data included too many highly paid executives, according to the report.

“It shows a high level of interest and an increasing level of sophistication” by regulators in the tax-exempt sector, says Ralph DeJong, a partner with McDermott, Will & Emery in Chicago.

The IRS examination looked exclusively at colleges and universities, but its findings can be applied to tax-exempt hospitals and health systems, which are subject to the same regulations and scrutiny, DeJong says. The findings suggest regulators will be more comprehensive as they review which organizations may be considered comparable for the purpose of determining the market rate for chief executive compensation, he says.

Critics contend those market rates are an illusion based on unlikely comparisons across multiple industries where the CEO isn't a true peer. Most top executives have knowledge and experience that is specific to their employers, and, therefore, is not transferable to other companies. “It's very clearly fictional,” says Craig Ferrere, a fellow in corporate governance at the Weinberg Center for Corporate Governance at the University of Delaware, who co-authored a working paper with Charles Elson, director of the center and a finance professor at the university. that criticized peer groups.

Rising executive pay has long been a flashpoint in the public debate over the nation's widening income gap. The sting of astronomical payouts to CEOs was heightened by the recession. While average citizens measure the tepid U.S. economic recovery by how much lost ground they have made up in the job market, housing prices and family income, they can't help but notice that chief executives barely got dented by the downturn. Paychecks for top executives rebounded quickly, separate analyses by the Associated Press and USA Today found, even as households continue to struggle.

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.

CHS said it would no longer set compensation for top executives using pay from companies outside of healthcare, such as Sara Lee, Whirlpool and ConAgra. Instead, Community Health Systems will rely on pay at 20 healthcare companies to set all top executive compensation. The group was selected based on market capitalization, enterprise value, workforce and revenue. Community Health Systems' revenue is “just above” the group's median.

ISS described the changes as “significant.” However, the health system's practice of benchmarking cash incentives to the 75th percentile was a continued source of concern for the shareholder group.

The vote against CHS' CEO pay package was a rarity. Few companies have “suffered the embarrassment” of shareholders who objected to executive compensation in advisory votes required at publicly traded companies under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, researchers wrote in a Vanderbilt University Law School working paper published in February.

Meanwhile, for tax-exempt hospitals and health systems, regulators have laid out steps necessary to demonstrate that governing boards have sought to avoid overpaying executives. One of those steps is to use comparable compensation data to justify CEO payment. Not-for-profits who wish to meet regulatory standards to demonstrate good governance must use pay comparisons.

But DeJong of McDermott, Will & Emory says it may be increasingly difficult to identify comparable organizations if the IRS broadly applies new standards for comparisons following its review of colleges and universities. That could leave comparisons more easily influenced by a single large payout. “There's a value in having a more robust set of peers, even if they're not quite as tightly comparable, but result in stronger, more robust data upon which to rely that not as influenced by outliers,” he says.

At the Mayo Clinic, a search is underway to fill the spot when Shirley Weis, Mayo's vice president and chief administrative officer, retires at the end of the year. The Rochester, Minn.-based health system cultivates potential executives within its own ranks because of Mayo's culture and size, says John Biermann, the Mayo Clinic's director of physician and executive compensation.

The system's scope of operations makes it difficult to find someone outside the organization with necessary experience to fill top vacancies, he says. Mayo's unusual management structure—which pairs physicians and administrators as joint managers—also complicates efforts to recruit externally for the health system's executive jobs. “That doesn't exist (at) most places,” he said. “It's pretty unique in healthcare. It's probably non-existing in industry.”

Biermann says he reviews compensation for nearly all Mayo employees to monitor differences in pay for inequality, but the market “gets in the way” of roping top executives' pay to that of managers. Mayo uses three sets of comparable compensation data, all of which are limited to academia or health systems. The system's top talent pool may be largely internal, but compensation for top executives is “pure market pricing.”

As long as compensation committees continue to be swayed by that logic, the wide disparities between top executives and the company's workforce will continue. And it comes at a price. They broadly undermine morale, loyalty and motivation for lower-paid workers, the University of Delaware scholars say.

It would boost productivity if boards considered benchmarking executive compensation to their own employees, whose pay and compensation packages more accurately reflect market conditions than ill-matched peer groups of fellow CEOs, according to Elson.

“Board ratification of the executive's contract should not be viewed singularly,” Ferrere and Elson wrote. “It is an implicit examination and approval of the entire organization's wage and incentive structure.”

Follow Melanie Evans on Twitter: @MHmevans