Do executive compensation consultants help ensure that CEO pay packages put shareholder interests before those of the CEO? Or do such consultants simply ratchet up executive pay, serving CEOs’ interests instead of the organizations’? In the past decade, an increasing amount of academic research has been focused on sorting this out. A 2017 Harvard Business School working paper, “Compensation Consultants and the Level, Composition, and Complexity of CEO Pay,” by Kevin Murphy and Tatiana Sandino examines CEO pay and use of compensation consultants.
Murphy and Sandino, using proxy statement data from a sample of 2,347 publicly traded firms in the United States between 2006 and 2014, found CEOs in firms retaining consultants have higher levels of total compensation than CEOs in firms not using consultants. This difference can be considered a premium paid to the CEO above the level of pay otherwise expected. The authors break down the premium into two groups: base premium received by CEOs when the consultants only provide the compensation consulting service; and additional premium (which adds on to base premium) for firms receiving services from the consultant beyond the compensation consultation.
The base premium has grown by 30%, from 37% in 2006 to 48% in 2014, according to Murphy and Sandino (See Figure 1.) Murphy and Sandino then continue by examining the impact of retaining compensation consultants who also provide other services to the firm. Interestingly, they find that this additional premium has dropped by nearly a third, falling from 23% in 2006 to 16% in 2014.
These results — shrinking pay premiums in firms with consultants providing other services and expanding pay premiums in firms using only executive compensation consulting services — is all the more interesting given the time period studied. The years 2006 to 2014 include the SEC’s introduction of mandatory disclosures regarding firms’ engagements of compensation consultants and the coverage by rules aimed at breaking linkages between the CEO and consultants.
But what about the argument that consultant services are a necessity, given the complexity of CEO pay? To better understand these dynamics, the authors examined the roles of the composition of CEO pay (i.e., the mix of base pay to bonus and performance pay) and the complexity of CEO pay (i.e., the number of different types of performance plans) on the relationship between CEO pay and consultants. Employing a richer set of statistical controls to account for composition and complexity, the authors did find that the estimated CEO pay premium is less. Allowing for the composition and complexity of CEO pay to mediate the role of consultants, Murphy and Sandino show that the estimated base premium associated with retaining a compensation consultant is reduced by 60% (from 8% to 3%), while the estimated additional premium for other services remained constant.
Association Is Not Causation
Does an organization with upward-ratcheting and complex CEO pay bring in consultants to help with that situation, or is it the presence of consultants that introduces the pay complexity and upward ratcheting? Which came first, the chicken (rising pay levels and complexity) or the egg (compensation consultants)? The authors found that chickens sometimes do precede eggs in this case. Firms not using consultants but with higher CEO pay and more complex pay (chickens first) are more likely to bring consultants in the next year (eggs second) than firms with lower and less complex CEO pay packages.
Murphy and Sandino concluded their study by considering if engaging consultants justifies CEO pay to shareholders. While there is a positive relationship between the retention of consultants and positive Say-on-Pay voting outcomes and ISS voting recommendations, the estimates are statistically insignificant. The interesting finding from this analysis shows that a larger composition of incentive-to-base pay as well as more complex pay are strongly associated with more positive voting results.
As with most things in life, the relationship between growth in CEO pay and compensation consultants is not simple. Even when examining a period marked by increasing scrutiny of consultants, there is evidence of notable pay premiums going to CEOs when compensation consultants are engaged. The causality of higher CEO pay and use of consultants, however, likely goes both directions, with firms independently offering higher and more complex pay being the firms most likely to retain consultants in the future. Shareholders’ and ISS’s preference for complex, performance-based plans reinforces all of these factors.
Better understanding the role of compensation complexity should help inform how best to align shareholder and executive interests. It is important to note that the SEC regulations were on the disclosure of information and not on the behavior of consultants. An extremely draconian action could have been to ban compensation consultants. Instead, the SEC’s path was one of increased transparency, robust information being an important characteristic of properly functioning markets.
Hassan Enayati, Ph.D., is a research associate for the Institute for Compensation Studies at the ILR School at Cornell University.