It stands to reason that every major company has a unique set of strategic goals. Consequently, it stands to reason that the chief executive’s compensation package should be uniquely designed to align to those goals, while addressing the individual goals of the CEO.
Why, then, do so many executive compensation packages look so similar to each other?
“Many of them stated that the design of the CEO compensation package was heavily reliant on the proposals produced by the compensation consultant”
That’s the main question Susanna Gallani pursues in her working paper Through the Grapevine: Network Effects on the Design of Executive Compensation Contracts. The answer could help to explain why CEO salaries tend to be very high across the board.
“There’s always been this black box surrounding what happens in the boardroom,” says Gallani, an assistant professor in the Accounting and Management unit at Harvard Business School. “For years I imagined this group of people sitting around a table, having to make very important decisions, such as defining the CEO’s compensation package. And I always wondered, what do they talk about? What is the information they use? What are the questions they ask? And more specifically, what are the sources of influence on the decisions that they make?”
At large public companies, boards of directors are usually in charge of how and what to pay their CEOs. It’s an expensive decision. Among the 350 top firms (by sales) in the United States, the average CEO compensation package added up to $15.2 million in 2013, according to the Economic Policy Institute. That compensation includes a vast array of factors, such as salary, bonuses, stock options, and long-term incentive payouts.
Ideally, the compensation package motivates the CEO to make decisions that benefit both the executive and the company. Among economic scholars, there’s a whole line of theoretical research dedicated to striking that balance.
“Compensation theory says that in order for compensation to be effective, you need to create a compensation package in a way that facilitates an alignment between the goals of the executive and the specific goals of the corporation,” Gallani explains.
But when Gallani examined the public records of public companies in the United States, she realized some disconnect between economic theory and economic reality. In spite of the unique goals of each firm, compensation packages often looked very similar from one firm to the next—both in terms of the distribution of fixed pay (salary) versus incentive pay (bonuses and stock options), and in terms of how CEO performance is measured.
THE NETWORK EFFECT
Gallani hypothesized two possible culprits for the isomorphism. The first was the issue of interlocking directorates. Many directors belong to the boards of multiple firms, which can create communication channels between those firms. For instance, a board member who helped design a compensation contract for Firm A might employ the same strategy when helping to design a contract for Firm B. “Board interlock is a conduit of information, but it’s also a source of influence,” Gallani says.
The second conceivable copycat contract cause: compensation consultation commonality. A compensation consultant is an independent advisor who helps shareholders decide what to pay their CEO. Compensation consulting firms often serve hundreds of corporate clients—e.g., leading firm Pearl Meyer has more than 1,000 clients, including many in the Fortune 500, according to its website.
Gallani wondered if a multitude of clients might lead to the creation of one-size-fits-all packages, or, because of the consultants’ dedicated expertise, would lead to expertly designed, customized compensation packages. “So the question was, Do compensation consultants tend toward more individualized solutions, according to what academic theory recommends, or are they drawn more toward similar, more popular solutions?” she says.
To address those questions, Gallani cold-called a bunch of public companies and asked whether they employed compensation consultants. “Many of them stated that the design of the CEO compensation package was heavily reliant on the proposals produced by the compensation consultant,” she says.
Gallani then analyzed the proxy statements of companies in the S&P 500 from 1998 to 2013, which included the names of the firms’ board members.
She created a complex Euclidean vector that enabled her to represent the multidimensionality of each compensation contract. She then conducted a one-on-one comparison, tracking similarities between compensation contracts in each pair of firms and noting which firms had board members or compensation consulting firms in common.
Gallani found that board interlock and compensation consultants had a definite effect on CEO compensation packages. In short, “When firms are connected in either way, the compensation contracts tend to be more similar than not,” she says.
When two firms had at least one board member in common, their compensation packages were decidedly more similar than in two firms with no board interlock. The similarities were especially apparent when the interlocked board members sat on the compensation committees of both companies. But those effects were only related to the ratio of base salary and incentive pay. In terms of how the boards measured success (financial performance vs. other measures), board interlock didn’t seem to have an effect.
Firms connected through compensation consultants showed an even greater similarity in their CEO compensation contracts. These contracts had high levels of similarity not only in their salary-to-incentive-pay ratio but also in the way they measured performance.
However, the size of a consultant’s customer base made a difference—and in an unpredicted way. Gallani had expected that the more clients a consultant had, the more similar the compensation contracts would be. In fact, consultants with large customer bases actually created more individualized contracts than those with small customer bases.
“To me what was most surprising was that there’s a double-sided effect,” Gallani says. “There is more similarity in general with the compensation consultants, but under certain conditions the similarity is mitigated.”
The next stage of Gallani’s research will focus on why that is. “That’s where I want to dive deeper,” she says. “I want to find out what drives some consultants to drive more unified solutions versus what drives some to drive more individual solutions.”
Gallani also wants to look into why there aren’t more government regulations to hold compensation consultants accountable for their role in determining CEO pay. She notes that while companies often hire compensation consultants, their individual names rarely appear on proxy statements.
“Auditors are held accountable,” she says. “But with compensation consultants, the only measure of accountability is their reputation.”
Note to readers: Susanna Gallani wants to know your impressions of compensation consultants—especially if your firm has hired one to help determine executive pay. Please share your thoughts in the comments section below. “I’d be interested in knowing what board members believe the accountability of the compensation consultant should be,” she says. “Should they have more responsibility? Should they have official responsibility, or should they stay in an advisory role?”