New Paper Examines Whether CEOs Are Overpaid

by: Sergei Barna

If you think that some CEOs are overpaid, you might be right and have the academic research to back you up. The latest issue of the Journal of Financial Economics has published a paper by Bizjak, Lemmon, and Nguyen ("Are all CEOs above average? An empirical analysis of compensation peer groups and pay design"), where the researchers examine peer group benchmarking by companies when determining compensation packages for their CEOs.

Peer group benchmarking is the practice that board of directors compensation committees use to determine the amount and the structure of CEO's pay. It involves identifying comparable firms, similar in size and belonging to the same industry (i.e. the peer group) and setting CEO pay in accordance with the common practices. The rationale is that peer group benchmarking allows the board to determine competitive compensation levels to help recruit and retain top executives. However, one major criticism of this practice is that it is used to inflate pay levels. As an example, the authors cite Regis Corp. (NYSE:RGS) (the owner of Vidal Sassoon and Supercuts) whose board included Starbucks (NASDAQ:SBUX) and H&R Block (NYSE:HRB) among its peers despite the fact that these firms are much larger, belong to different industries and have significantly higher CEO compensation than Regis.

The paper examines compensation data for hundreds of firms and finds that while firms in the S&P 500 tend to stick with justifiable selection of peers, smaller firms (not in the S&P 500) tend to bias their selection towards larger firms with higher compensation, which strengthens the CEO's negotiating position for next year's pay. The authors show that on average, S&P 500 CEOs were able to get an annual increase in pay covering 33% of the gap between the peers, and the non-S&P 500 CEOs cut the gap by 27%.

Moreover, the average pay targets were above the peer group median—56.2% for S&P 500 firms and 54.7% for non-S&P 500 firms. This pay-targeting implies that an average CEO is better than the average CEO. Does that make sense to you? Consistently following such pay-setting year after year would quickly inflate the average CEO pay which is what the critics have been claiming for years.

The situation may be improving somewhat since the adoption in 2006 of the new SEC regulations on compensation disclosure. The authors find that 25% of the firms in their sample reduced the bias in their peer selection in the two years following the adoption of the new regulations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.