NACD - National Association of Corporate Directors

Can You Manage Peer Group Disputes?

by Bill Reilly |

bill reillyCompensation committees are taking a more active role in reviewing and approving the peer groups used for market benchmarking. While this is driven by the continuing scrutiny of executive compensation from outside the company, a more active role can lead to internal disagreements between committee members and management because executives might have a more aspirational view of appropriate comparator companies.

Executive pay tends to correlate with company size, due to the greater complexities of larger companies. Other considerations when constructing a peer group include business strategy and life cycle, product mix, target customers and markets, capital structure, and geography. The compensation committee’s objective is to establish a meaningful sample of comparably sized organizations that have similar characteristics and that compete with the company for business, talent, and investor capital.

As compensation consultants, we often are asked to develop peer group recommendations and then build consensus among compensation committees and management. We have found that the following approaches can address and resolve conflicts over peer group composition:

■Establish a secondary reference group of size outliers to address management concerns about reviewing pay data and practices for large direct competitors. Data for these “below the line” reference companies would be excluded from market-value statistics.

■Use regression analysis to adjust market pay levels in cases where a company’s direct competitors are generally larger in size. (Calculations may be impacted by sample size and how correlated pay levels and company size are.)

■Expand the relative size range for peers beyond the typical level (e.g., 33% to 300%, instead of 50% to 200%), while continuing to exclude significant size outliers, with the company positioned near the median.

■Align target pay positioning with relative size versus peers. For example, if the company’s size is at the 33rd percentile, target pay could be positioned similarly.

The Benefit of Multiple Perspectives

While companies often use one comparator group for market benchmarking, there are times when multiple peer groups may be useful. Companies headquartered in highcost areas or with diversified business units, for example, can benefit from multiple perspectives. Supplemental peer groups can also be useful in the following situations:

Externally reviewing incentive plan design. While primary emphasis should be on a company’s unique needs and circumstances, understanding the practices of direct competitors can be helpful when reviewing existing or proposed incentive plan designs.

Calibrating incentive plan performance goals. Direct competitors can provide a more meaningful basis of comparison than comparably sized organizations with a broader industry focus when evaluating the degree of rigor for incentive plan performance goals or correlations with long-term shareholder value creation from an external perspective.

Comparing relative performance. Relative performance comparisons versus direct industry competitors without regard to size can provide a useful frame of reference. Relative total shareholder return comparisons, for example, may be made using industry-specific or broader market indexes.

Validating Pay Practices

Supplemental peer groups also can be used to assess the prevalence and structure of certain pay practices, such as transaction-related incentives, supplemental awards for exceptional performance, or retention bonuses.

Market benchmarking is one of many inputs relating to executive compensation. An effective compensation program should reinforce a company’s business strategy, corporate culture, talent management initiatives, and other objectives. It also should be flexible enough to evolve with changes in strategy and market trends.

While external market practices and shareholder advisory group policies should inform, rather than drive, executive compensation design, compensation committees should ensure the peer groups used in market benchmarking and executive pay determinations are defensible. Consider how your peer group data will be analyzed and how multiple perspectives may provide a clearer picture of relative performance and pay outcomes, and help support decisions that are in the best long-term interests of the company, even if at odds with shareholder advisory group policies.