Pay Harmony: Peer Comparison and Executive Compensation
Executive Summary — This paper demonstrates how horizontal wage comparisons within firms and concerns for "pay harmony" affect firm policies in setting pay for executives. Using a rich dataset of pay practices for the senior-most executives within divisions, Gartenberg and Wulf ask whether horizontal comparisons between managers in similar jobs affect pay. The authors also evaluate evidence in support of a tradeoff between pay harmony and performance pay. Findings are consistent with the presence of peer effects in influencing pay policies for executives inside firms. These results contribute to the ongoing policy debate on the consequences of transparency and mandatory information disclosure and potential ratchet-effects in executive pay. For practitioners involved in designing the structure of executive compensation and pay disclosure policies for firms -- including compensation committee directors, senior human resource executives, and compensation consultants -- it is important to recognize the tradeoff between the incentive effects of performance-based pay and costs of peer comparison that arise from unequal pay when designing executive wage contracts. The research also raises questions on the costs of pay disclosure and on labor markets more generally. Key concepts include:
- Pay policies of firms respond to concerns about internal equity.
- An SEC ruling in 1992 led to greater awareness of pay and greater peer comparison throughout all managerial ranks, particularly in geographically-dispersed firms that had natural information barriers prior to the ruling, as well as in firms with less ex ante pay disclosure.
- From the perspective of firms, the consequences of increased pay disclosure may range from pay ratcheting to aggregate shifts in worker effort or firm-specific investments and turnover.
- From the perspective of employees, increased pay disclosure may influence decisions to join firms and shift the relative importance of internal and external benchmarks, thereby having larger labor market consequences.
Using rich panel data on division manager pay, we investigate whether peer effects in the form of horizontal wage comparisons affect firm policies on executive pay. We find pay co-movement (or pay-referent sensitivity, PRS) to be more pronounced in geographically concentrated firms where we expect divisional proximity to facilitate information sharing about pay and magnify peer comparisons. To separate the peer effect of PRS from other factors that may drive co-movement of firm pay, we exploit exogenous increases in access to pay information using the SEC 1992 Proxy Disclosure Rule that differentially affected firms. Based on differences-in-differences models, we find increased PRS and decreased pay-performance sensitivity (PPS) after 1992 within geographically dispersed firms relative to firms with proximate divisions. The effects are strongest in dispersed firms with relatively less pay disclosure prior to 1992, a subsample for which the ruling had a relatively larger impact. Finally, based on analysis of manager pairs within a firm, we find that mean distance in pay between different-state managers increased by less relative to same-state managers after the rule change. Taken together, our findings suggest that peer comparison decreases pay disparity within firms and that principals face a tradeoff between the incentive effects of performance-based pay and costs of peer comparison.