Has the Use of Peer Groups Contributed to Higher Pay and Less Efficient Compensation?

Abstract

We provide empirical evidence on how the practice of competitive benchmarking affects CEO pay. We find that the use of benchmarking is widespread, and has a significant impact on levels and changes in CEO compensation. The practice is controversial and one view is that it is inefficient because it can lead to increases in executive pay that are not tied to firm performance. A contrasting view is that benchmarking can be a practical and efficient mechanism to gauge the market wage necessary to retain valuable human capital. Our empirical results provide some support for the latter view. We find that firms use competitive benchmarking to gauge the reservation wage necessary for retention. Our analysis also provides an alternative explanation for the documented asymmetry in the relationship between CEO pay and luck, which has previously been attributed to rent seeking behavior.

Keywords: Compensation, peer groups, compensation committees, CEO pay

JEL Classification: G30, G34, J31, J33