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Benchmarking and Survey Use
- Problems with Surveys and Benchmarking
- Types of Bias in Surveys
- How to Correct Survey Bias
- Key Peer Group Questions that Compensation Committees Should Be Asking
- A Practical Tool for Boards to Implement: Internal Pay Equity
- Practice Pointers
- Firm Memos
- Media Articles
- Benchmarking Disclosures Practice Area
- Problems with Surveys and Benchmarking
The common practice when reviewing a CEO’s compensation is to refer to
executive compensation surveys. Unfortunately, as compensation consultants now
readily acknowledge, surveys are not just flawed and biased, they can be
massaged and cherry picked to come up with pre-ordained results that a CEO has
either explicitly requested or that the consultant has derived to ingratiate
him/herself with the client. The consultant might deliver a report to the
compensation committee with an incongruent pair of "peer" companies: one set for
purposes of executive compensation and another for corporate performance.
In these surveys, it is easy to inflate numbers by including extraordinary or
one-time payments and grants, or by relying on surveys conducted for other
companies that included such items. This reliance might even be unintentional.
On top of all this, as more companies adopted the practice of
"benchmarking"—taking the position that their above-average CEO should be paid
in the top 25th percentile of all CEOs—a slippery slope resulted. Compounded
each year, benchmarking quickly became an out-of-control ratcheting-up
phenomenon that resulted in exponential growth in compensation, as this year’s
top 25th percentile becomes next year’s 50th, requiring another increase to get
back into the top 25th, and so on.
Another problem is that these surveys often do not take into account that
some companies may put greater emphasis on cash compensation than stock options,
while other companies may place greater emphasis on long-term incentives. By
cherry picking from each category, a CEO can have his cake and eat it too.
All of this can help largely explain how at some companies CEO salary and
bonus and stock grants and other components of CEO compensation have gotten so
far out of line—not just from the median workforce salaries generally, but also
from other senior and mid-level compensation levels at the CEO’s own company.
It still is troubling that many compensation consultants, who acknowledge how
surveys have brought CEO compensation into the stratosphere, still use those
inflated survey numbers—that have years of compounded inflated numbers built
into them—to help clients determine what is the appropriate level of salary,
bonus and other compensation. This continues to perpetuate all the mistakes of
the past. Going to a 50th percentile now—which may have been last year’s 25th
percentile and which would have been off the charts just a few years earlier—is
not reform.
Compensation committees cannot afford to ignore the admonitions about surveys
in recent governance reports: "The committee should resist an over-reliance on
surveys and other statistical analyses in determining compensation levels."
(Business Roundtable) "So-called market-based compensation…is a root cause of
the current problem." (NACD Blue Ribbon Commission) "Percentile benchmarking
should not ever be practiced except to provide broad market reference points."
(Breeden Report).
And here is what the Council of Institutional Investors included in its
recently updated policy on executive compensation: "Benchmarking at median or
higher levels is a primary contributor to escalating executive compensation.
Although benchmarking can be a constructive tool for formulating executive
compensation packages, it should not be relied on exclusively. If benchmarking
is used, compensation committees should commit to annual disclosure of the
companies in peer groups used for benchmarking and/or other comparisons. If the
peer group used for compensation purposes is different from that used to compare
overall performance, such as the five-year stock return graph required in the
annual proxy materials, the compensation committee should describe the
differences between the groups and the rationale for choosing between them. In
addition to disclosing names of companies used for benchmarking and comparisons,
the compensation committee should disclose targets for each compensation element
relative to the peer/benchmarking group and year-to-year changes in companies
composing peer/benchmark groups."
For more information, see this practice pointer by Fred Cook regarding "The Problem with Surveys."
- Types of Bias in Surveys
Fred Cook, Chair of Frederic W. Cook & Co., illustrates how surveys can be
biased in a dozen ways, such as:
- User Bias. Companies that sponsor surveys often do so with an
implicit (albeit unstated) objective: to show the company as paying either
competitively or somewhat below the market so as to justify positive corrective
action. Those who are contracted to conduct the survey and interpret its results
on the company's behalf subconsciously take on these same objectives. This user
bias does not by itself cause salary inflation, but it does create the climate
in which upward bias occurs and is accepted.
- Sample Bias. Companies like to compare themselves against
well-regarded, high-paying, and high-performing companies. Those firms that
participate in surveys drawing data from a large number of other organizations
often have the ability, through computer technology, to create a subset of
participants with whom they wish to compare themselves. This typically results
in a higher competitive pay line than the general survey, thereby showing the
user company in a more favorable (i.e., less competitive) light in terms of pay
rates.
Alternatively, the survey may be custom designed, in which case the
sponsoring company will tend to select a high-paying, high-performing group of
companies against which to compare itself. The survey designers will exclude
low-paying (and less well-regarded) companies. It is perfectly natural to want
to compare oneself against the star performers in an industry; this reflects the
company's goal to become more like the leaders.
This would be fine if surveys compare relative performance as well as
relative pay. Most do not. Actually, paying less than others may be quite
appropriate if the company's performance is low relative to the survey sample.
Likewise, high pay may be justified by high performance.
What happens, however, is that the low-paying company will downplay its
relative performance and use the survey to justify pay increases, while the
high-paying company justifiably maintains its high position based on its
relative performance. The net effect, over time, is upward movement in
competitive pay levels.
- Survey Selectivity. Most companies have access to several surveys
covering the same population. In cases where different surveys show the company
in different competitive positions (some more favorable than others),
compensation professionals tend to disregard, challenge, or downplay those
surveys that do not show the company in the desired competitive position.
- Scope Bias. Survey professionals accept the idea that the relative
size of the organization should influence its pay, particularly at upper
management levels. Yet "size" can be measured in any number of ways: revenues,
equity, assets, market capitalization, net income, etc. Sponsoring organizations
tend to select size variables that let them compare themselves favorably to the
survey companies. Thus, if revenues are high but market capitalization is low,
they will select revenues as the variable.
If every company in the survey has the ability to select the size or
performance variable that favors itself, then it is technically feasible for all
companies to show themselves as paying below the market. When this happens, what
is the real market?
- Compensation Selectivity. A total compensation package is composed
of many elements, whereas most surveys tend to focus on a few, such as salary
and bonuses. It is natural for companies that have a competitive total
compensation package to be light on some pay elements and heavy on others.
Companies with very generous benefit packages, supplemental executive retirement
plans (SERPs), or large equity grants tend to disregard or downplay those pay
elements in conducting surveys. If a company surveys only those areas where it
is light (cash compensation, for example), it should not interpret or use those
findings in isolation. If it does, it will be raising its total compensation
levels above the market.
- Benchmark Bias. In submitting survey data and interpreting the
results, companies must match their positions against positions in the survey.
In doing so, they tend to match their positions against those that have higher
responsibilities and hence higher compensation. One company's positions may not
have the full scope of responsibilities typical of that position in other
companies. But the interpreter will tend to disregard this when comparing pay
levels. Conversely, if a company's position shows up as highly paid relative to
the survey, the interpreter will explain that away by saying that the position
has more responsibilities, a different reporting relationship, or other factors
that justify higher pay. Since very few benchmark positions are perfect matches,
it may be quite appropriate to adjust survey data for differences in position
responsibility. But, if this is done to explain and justify a higher-paid
position, then equal efforts should be made to explain and justify those that
are paid below the market.
- Statistical Bias. Survey professionals use a variety of statistical
techniques to interpret the survey results and determine where a particular
company stands against the survey population. Single and multiple regression
techniques are often used to supplement straight statistical averages, medians,
and quartiles. A sponsor motivated by a desire to have the company appear in a
good light can select, from among the statistical techniques available, those
that will support this purpose. This problem will grow worse as sponsoring
companies become more sophisticated in using option-pricing models to compare
the values of equity-based, long-term incentive grants. By manipulating the
variables and assumptions in ways favorable to the company, the interpreter may
be able to make an above-competitive grant practice appear less generous and the
grant practices of others appear more generous.
- Converting Actual Bonuses into Target Bonuses. Many companies use
surveys to assess and reset their target bonus practices as a percent of salary.
However, most surveys collect data on actual bonuses, not target bonuses. In
times of strong economic expansion and performance, it is common for actual
bonuses to be above the target level. Companies that rely on high actual bonuses
reported in the survey to justify raising their target bonuses lead the way in
escalating total pay levels over time.
- Results Bias. Having a strategy of paying competitively based on
performance means a company is obligated to offer a competitive pay opportunity,
not guarantee a competitive result. For example, a position may have a target
bonus payout of 30% of salary, set so that the base salary plus the target bonus
would result in competitive total annual pay when performance standards are met.
However, there is no guarantee that the target bonus will be paid or that total
pay will be competitive.
Companies may overlook this obvious truism when they have low or no payouts
under annual bonus or long-term incentive plans in comparison with others that
have made higher payouts, perhaps because of better performance. Low payouts
relative to the competition may be perfectly justifiable and not a cause for
corrective action. Surveys that include payouts from variable pay plans should
be interpreted with reference to relative performance data. In the absence of
such data, surveys should focus on competitive opportunities, not results.
- Misinterpretation and Normalization of Special Equity Grants.
Increasingly, companies make special equity incentive grants to their key
people. For example, instead of making smaller stock option grants every year, a
company may accelerate option grants into a single, jumbo grant. Or it may give
executives a special, one-time equity grant to signal a significant event, such
as a new strategy or a merger. Finally, when hiring a senior executive from
outside, the employer may use special equity grants to induce the executive to
take the job or to make up for benefits lost in the job change.
These special grants more often than not are included in the survey
collection process. Without knowing the reasons
for the grants, the survey interpreter may assume that they are part of a
normal granting practice. Even knowing a grant is a one-time special event, the
interpreter may normalize it by assuming it will be repeated every three or five
years. The net effect is to raise the survey averages to new levels and to
create a situation where special grants by one company become built into
normalized practices by the survey population.
- Value Bias. Some employees are true "value builders" and rewarded
as such. Others are "value maintainers," and some are, in fact, "value
destroyers" because they are paid more than they are worth. Surveys, however, do
not distinguish among these categories. When a survey includes pay data from
across the value spectrum, survey averages are pulled up by the justifiably high
pay of the value creators. These averages, however, are used to rationalize
higher pay levels for value maintainers and destroyers as well in order to be
"competitive."
- No-Decline Bias. Compensation professionals have grown to expect
that survey data will show pay rates rising every year. A conceptual framework
does not even exist for handling marketplace declines in pay. However, with all
the layoffs, downsizings, and early retirements of higher-paid workers, one
would think surveys would show declines in market pay rates.
Even if a survey shows a decline in pay rates, the user will tend either to
disregard or reinterpret the data to reflect an increase. Also, survey purveyors
know that steady increases in competitive pay levels are good for business, and
declines are not. This, combined with user bias, may explain why surveys
continue to show increasing pay levels.
- How to Correct Survey Bias
In addition to some of the practice pointers below, Fred Cook, Chair of
Frederic W. Cook & Co., provides some tips on how to correct survey bias. Fred
notes: "If there were no compensation surveys, there probably would be wider
disparities among company pay practices than exist today. These disparities
would tend to be more economically justifiable, both on the high and the low
side. Natural economic forces would operate to create a market in which people
would be paid according to their relative worth.
Surveys tend to narrow the disparities, particularly on the low side, because
low-paying companies use them to justify pay increases that otherwise would not
be justified. They tend to have less effect on the high side because
high-performing companies can justify high pay and will do so rather than using
the survey to depress their pay levels. By pulling up the bottom, surveys raise
the average for everyone, thereby causing an upward escalation in overall pay
levels.
How can you avoid the negative effect of bias? I propose three solutions.
First, acknowledge that upward bias exists in surveys and act to correct it
where possible. Second, downplay the importance of surveys use them as a check
on where you are, not as a rationale for doing something different. And third,
use relative size and performance comparisons in a justifiable and consistent
manner in interpreting any survey results."
- Key Peer Group Questions that Compensation Committees Should Be Asking
- Value of, and need for, periodic review and reassessment of the
composition of the peer group(s) being used, taking into account, among
other things:
- industry, size (based on market cap, revenues, etc.), business
orientation, organizational style and other similarities and differences
between company and various potential comparators;
- relative financial and non-financial performance of the company (and its
senior executives) vs. comparators (and their senior executives) currently
and over last 2-3 years; and
- any major changes in, and developments regarding, the Company’s business
focus and its longer-term strategic goals. Is the Committee looking at a
full set of peer group data points? For example. . .
- Does the peer group data on annual bonuses look at target award
opportunities as well as actual payouts?
- Has the data on comparator company bonuses, option grants, and
restricted stock and RSU awards been weighted or otherwise adjusted to take
into account relative annual and longer-term financial and strategic
performance and any special circumstances at those companies?
- Have the recent Form 10-Q, Form 8-K and Form 4 filings for comparators
being fully reviewed to identify what current-year data is available
regarding new and amended employment agreements, new equity-based grants,
stock option exercises, restricted stock vesting, stock sales, etc., in
addition to the data already shown in the comparator companies’ most recent
proxy statements?
- Note impact of new Form 8K disclosure requirements scheduled to take
effect in August 2004. 5. How good an understanding does the Committee have
regarding the primary interactions between annual salary, bonus and other
compensation decisions and the affected executives’ severance, deferred
compensation and retirement benefit rights?
- Has the Committee been provided with sufficient information regarding
the impact of any recent or proposed large cash (and, if applicable,
non-cash) compensation actions (e.g., large salary increase or large bonus)
on the executive’s severance rights and supplemental retirement benefits?
- A Practical Tool for Boards to Implement: Internal Pay Equity
- Practice Pointers
- Companies that Use Internal Pay Equity
- Practice Pointers
- Executive Accountability and Defensible Executive Pay
—Mark Van Clieaf, MVC Associates International
- The Problem with Surveys
—Fred Cook, Frederic W. Cook & Co., Inc.
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The New DNA of Corporate Governance
—Mark Van Clieaf, MVC Associates International
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Steps to Take to Avoid Director Liability
—Mark Van Clieaf, MVC Associates International
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Executive Accountability and Excessive Compensation: A New Test for Director Liability
—Mark Van Clieaf, MVC Associates International
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Referring to Surveys No Longer Enough: Work Valuation for Executives
—Blair Jones and Peter LeBlanc, Sibson Consulting
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An Example of a Board Chairman’s Revelation About Peer Groups
—Mark Van Clieaf, MVC Associates International
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Using Company-Centric Performance Measurement
—Althea Day, Morgan, Lewis & Bockius LLP
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Incorporating Performance and Trends into Compensation Planning
—Beverly Aisenbrey, Frederic W. Cook & Co.
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Glaring Problems with Survey Data
—Mark Van Clieaf, MVC Associates International
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Subtle Management Bias From Consultants Can Emerge Over Time
—Anonymous Task Force Member
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How to Review Survey Data: Questions to Ask
—Tracy Bean, KPMG LLP
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Agreements and Surveys
—Tim Sparks, Compensia
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Compensation Surveys Are Biased
—Fred Cook, Frederic W. Cook & Co.
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Key Peer Group Questions that Compensation Committees Should Be Asking
—Anonymous Task Force Member
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The New DNA of Corporate Governance: Strategic Pay for Future Value
—Mark Van Clieaf, MVC Associates International, Janet Langford Kelly, Zelle, Hofmann, Voelbel, Mason & Gette
- Firm Memos
- Media Articles
- "Outside Advice on Boss's Pay May Note Be So Independent," Gretchen Morgenson, New York Times (4/10/06)
- "Oohs and Ahs at Delphi's Circus," Gretchen Morgenson, N.Y.Times (11/13/05)
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"CEOs' Pay Gets Stricter Scrutiny By Boards," Deborah Lohse, Mercury News (5/20/05) (registration required, but free)
- "Benchmarking Inflates CEO's Salaries," (AP) N.Y. Times (3/29/05)
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"Grasso's Pay Was Benchmarked to Top CEOs," Javier E. David, Reuters (2/5/05)
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"What Directors Think: Annual Board of Directors Survey," PwC and
Corporate Board Member Magazine (10/04)
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"What Really Happened to CEO Pay in 2002," Paul Hodgson, The
Corporate Library (6/03)
- "Executive
Excess 2003: CEOS Win, Workers and Taxpayers Lose," Institute for
Policy Studies and United for a Fair Economy (8/23/03)
- "Grasso Takes More Heat on Pay,"
Kate Kelly, Wall Street Journal (4/20/04) (article available for
purchase by online subscribers) (regulators are investigating whether
Grasso manipulated pay process by inappropriately influencing
compensation consultant and forcing board members to make hasty,
uninformed decisions)
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"Does the Use of Peer Groups Contribute to Higher Pay and Less Efficient
Compensation," John M. Bizjak, Michael L. Lemmon and Lalitha Naveen
(4/04)
- Benchmarking Disclosures Practice Area
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