Wrestler Frank Leavitt, Chicago, 1924 (Source: Wikimedia Commons)
Ideas for Leaders #457

How CEOs Strong-Arm Their Compensation Consultants to Get What They Want

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Key Concept

While previous research has never shown a direct link between the hiring of compensation consultants and increased CEO pay, a new SEC requirement allows academics to test more rigorously for a link: and they find it. According to the research, compensation consultants are used by CEOs as the means to justify higher pay.

Idea Summary

Does hiring compensation consultants result in higher pay for CEOs? Until recently, academic studies exploring this question have yielded no evidence that CEOs use compensation consultants to justify higher pay. A new disclosure requirement from the Securities Exchange Commission (SEC), however, allows researchers to better differentiate the potential motives behind the hiring of compensation consultants — and to prove empirically that there is indeed a link to higher pay for CEOs.

Before the rule change in 2009, many companies hired multiservice firms to advise them on executive compensation as well as for other services, such as guidance on pension plans. In 2009, a new disclosure rule required companies who purchased other services from their compensation consultants to disclose the fees paid for both compensation advice and other services. The disclosure rule, however, did not apply to fees paid to consultancies that only provided compensation services. As a result, a number of multiservice firms decided to spin off their compensation services into separate companies, thus allowing their clients to avoid the SEC disclosure.

The difference between multiservice firms and compensation specialist firms is significant. It was long believed that CEOs hired multi-service firms to gain an advantage: specifically, multiservice firms would want to make the CEOs who hired them for other services happy, notably by recommending increased competition for those CEOs. 

The new disclosure requirement thus allowed researchers to use three different measures to explore the connection between compensation consultants and CEO pay increases.

First, they compared CEO pay levels at companies that stayed with multiservice firms after the new disclosure rule went into effect to companies that switched to compensation-only specialists. The reason: companies that stayed with multiservice firms were legitimately benefiting from the non-compensation services they received prior to the new rule; companies that switched to compensation-only firms effect were, in fact, using the acquisition of the firms’ other services to influence them to suggest higher pay raises.

Second, they compared CEO pay levels at companies whose CEOs had hired compensation consultants after the rule change to companies whose consultants continued to be hired only by the board. Once again, the issue was leverage: a CEO who hires the consultant has more leverage to influence the consultant to recommend top-end compensation.

Third, they looked at the evolution of CEO pay levels at companies that hired compensation consultants for the first time. The researchers asked two questions: Did pay increase after the consultants were hired? And were the new consultants fired if there was no increase in pay?

The results were unequivocal. Six years worth of data concerning 1,000 companies demonstrated that CEOs were gaining and using their leverage over compensation consultants to get higher pay recommendations. The research showed that:

  • After the new disclosure rule came into effect, companies that switch to compensation-only firms paid CEOs an average of 9.7% more in total compensation than companies that stayed with their multi-service firms.
  • CEOs in companies that used only board-hired consultants were paid 12.9% less than their counterparts in companies that had both board-hired and CEO-hired compensation consultants.
  • Finally, CEOs received a median pay increase of 7.5% when a compensation consultant was hired for the first time — and, in most case, if CEOs did not receive an increase, the new consultant would be fired the following year.

Business Application

In the minds of many, CEO compensation packages have reached astronomical levels, especially when compared with the compensation levels of their frontline employees. Others argue that given the responsibilities and pressures involved, multi-million-dollar compensation packages are warranted.

Sympathetic boards are often blamed for the princely sums that today’s executives receive. This research reveals, however, other ways that CEOs can manipulate their pay packages, ensuring that they receive maximum compensation. Boards and shareholders must be vigilant that CEOs earn their pay, and are not being rewarded by compensation consultants who have a vested interested in recommending what the CEOs want to receive. 

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Institutions

Source

Idea conceived

  • September 2014

Idea posted

  • November 2014

DOI number

10.13007/457

Subject

Real Time Analytics