You’re asked by your company’s board of directors to reexamine your executive compensation. How, they want to know, does the company’s executive pay stack up when compared against other organizations?
The first thing to do is to decide which companies should make up your peer group. Should you compare to the companies against whom you compete for business? Those whose revenues are approximately the same as yours? Companies with about the same number of employees? Those in the same industry?
Isn’t there someone out there who can just hand you a list of the best companies against which you should compare?
Before you get too frustrated, bear in mind that this kind of self-examination is relatively new. It’s only been since 2006, when the Securities and Exchange Commission began requiring publicly traded companies to disclose their peer groups, that the information became readily available to the public. If you’re thinking about the best way to choose a peer group, you’re ahead of many companies, even very large ones, says Aaron Boyd, a researcher at Equilar (www.equilar.com).
Properly setting pay is always important because it can mean the difference between attracting the talent you need or losing them to another company. But as the recession begins to pull back, you especially need to make sure your pay package is competitive by comparing yourself against a well-chosen group of peer companies.
With the recent availability of peer group data, Equilar, which studies executive compensation data, decided to compile the information so it can be easily analyzed. The company also created a tool that allows clients to perform ‘what-ifs’ by plugging different companies into their peer group models, and learning which companies are benchmarking back to them.
“Choosing a peer group is a tricky thing,” says Boyd. And while you might wish they would, Equilar will not provide you with a list of recommended peers. “But we can help you,” he explains, “if you’re looking for a list of companies that fall within a certain range of revenue, or market capitalization, or whatever metric you want to use. The tricky part is that this isn’t as much of a science as it is an art; the companies you feel are most closely aligned to your business model, with whom you compete, who are around your size, may not feel that you are comparable to them.
“So there is not a specific list of companies that you should be benchmarking to. Instead, the challenge is figuring out which companies will provide the right group for you to make your compensation decisions.”
Size Matters—And So Do Other Factors
Why is the selection of your peer group so important? Boyd offers this exaggerated illustration. A mom-and-pop store that benchmarks itself against Wal-Mart, Target, and Kohl’s would find CEO pay that is much higher than what they would need to pay, he says.
“It would be much higher than what would be feasible, or even sensible, for that company. If you choose a peer group, then, of companies that are much larger and more complex than your company, there is the potential that you will overpay your executives. And conversely, if you were to underpay them because you chose companies that are too small and with jobs that just aren’t comparable, you end up paying less than they can get elsewhere. Then you run the risk of losing them to another company,” Boyd explains.
“Proper selection of your peer group is the foundation of a sound compensation program,” he emphasizes. “If you’re comparing to the wrong group of companies, then any assumptions or decisions, no matter how sound within that peer group, could potentially be errant and viewed as bad decisions, simply because you’ve got the wrong group of companies.”
Have Some of Your Peers Evaporated?
A close examination of your compensation peer group is especially important now, says Boyd, in light of the recent economy. Equilar’s research found that the average peer group consists of 16 to 20 companies. But due to mergers, acquisitions, and outright business failures, you may find that your peer group has shrunk in the last 12 months or so. “If you had a peer group of 20 and now you have 10, you might want to add some more companies,” he recommends.
Start with a frank discussion with your compensation consultant, Boyd says. “I’m not a consultant, but, anecdotally, from what I’ve seen and from talking with clients, most companies choose peers from among the companies they’re competing with. You know which companies you’re competitive with in terms of talent, revenue dollars, and other factors. They might be within your industry, but not necessarily. For example, Wal-Mart uses multiple peer groups. It doesn’t just compare itself against other retailers. It is the largest retailer by far, so to compare itself only to other retailers would be limiting.”
Some companies prefer to benchmark against an index, rather than choosing a group of specific peer companies. “They’ll review their performance relative to the S&P 500, for example. So when they’re figuring out how much they should pay out in a bonus, they’ll be comparing against companies they feel are comparable in terms of performance. Sometimes using an index might be the best strategy, especially if you consider how things went last year.”
He explains that, if bonuses depend upon company performance hitting a particular mark, that mark may have been unattainable in the depressed economy. But if your company’s performance met or exceeded that of the index group, you may actually consider the year successful and pay out the scheduled bonuses.
“One thing we noticed in our report was the relative size against which companies compare themselves, in terms of revenue, tends to be companies that are ½ to 2 times their own size,” Boyd says. “From there, they may refine their list, bringing in other factors. That way they don’t compare themselves with companies that are too large, or too small.”
Peer Group ‘Arms Race’
Boyd says that pay ratcheting is a concern when companies compare themselves to their peer group. “For instance, you decide to set your CEO’s pay above the median of the peer group. Then other companies see that figure and want to set their CEO pay above the median, which has now increased because of your strategy. Then you have to increase yours, and they increase theirs, and so on. It becomes like an arms race.”
“There isn’t really a silver bullet approach of exactly how you should build your peer group,” Boyd explains. “Each company really has to examine how they want to set their pay, which companies they feel comfortable comparing themselves to, and how they want to structure it.
“It is very much an individual thing. You don’t want to set your peer group and your pay structure the same as everybody else does, because there are unique challenges to every company. In order to reflect those differences, each company needs to take all these things into consideration when they’re selecting their peer group.”