Relative Performance Benchmarks: Do Boards Get It Right?

by Paul Ma, Jee Eun Shin, and Charles C.Y. Wang

Overview — Use of relative performance based (RPE) grants has been steadily increasing. Common wisdom is that such grants help induce costly effort from the CEO by shielding them from performance shocks that are outside of their control. This study raises questions about the use of index-based benchmarks in lieu of a narrower set of specific peers.

Author Abstract

Standard principal-agent models suggest that boards design incentive contracts that filter out common shocks in performance to motivate costly effort from the CEO---a process entailing the judicious selection of benchmarks for relative performance evaluation (RPE). We evaluate the efficacy of firms' chosen RPE benchmarks and document that, relative to a normative benchmark, index-based benchmarks perform 14% worse in their time-series return-regression R2 and 16% worse in measurement error variance; firms choosing specific peers only modestly under-perform. Structural estimates suggest that, absent frictions, the underperformance of index-based benchmarks imply a performance penalty of 106-277 basis points in annual returns. Consistent with these estimates, firms choosing index-based benchmarks exhibit lower annual returns and ROA. Finally, reduced-form analyses suggest that the inefficient benchmarking is associated with governance-related frictions. Collectively, these findings provide new evidence on the explicit practice of RPE and its implications for corporate governance and firm performance.