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Compensation consultants lead to higher CEO pay

Consultants a ‘justification device’ for higher executive pay, says study at Cambridge Judge Business School.

Pay Raise Just AheadA study of more than 1,000 US companies over six years finds “strong empirical evidence” that executive-pay consultants have been hired as a “justification device” for higher CEO pay, according to research led by Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge Business School, University of Cambridge.

The study was able to find such a direct link through the help of a 2009 US Securities and Exchange Commission (SEC) rule change requiring companies to disclose fees if consultants provided compensation along with other services. The new SEC rules resulted in a significant increase in boutique compensation-only consultants, many spun off by the largest multi-service providers, and higher CEO pay at companies that hired the boutiques.

The study shows a direct link between the hiring of executive-pay consultants and higher CEO pay itself.

“The study also shows that the SEC rule change didn’t work as designed, because both company management and pay consultancies have found ways to circumvent the intent of the new rules,” he said.

There has long been grumbling about executive pay and how compensation figures are arrived at, particularly in the US where CEO pay is highest. In the 2005 annual report of Berkshire Hathaway, Warren Buffett remarked: “The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accomodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.”

That said, previous literature had found little evidence that hiring consultants leads to higher pay mainly because they are unable to distinguish whether poorly governed companies hire compensation consultants to increase pay or whether the compensation consultant increases pay after controlling for the governance at the client firm.

The new study at Cambridge Judge – entitled Do Compensation Consultants Enable Higher CEO Pay? New Evidence from Recent Disclosure Rule Changes – “finds strong empirical evidence for the hiring of compensation consultants as a justification device for higher executive pay.”

The research, based on studying more than 1,000 US companies from 2006 to 2012, makes three key findings:

  • Companies that start hiring compensation consultants (firms which had none previously) show a 7.5 per cent increase in CEO pay compared to other firms, and such companies where CEOs get a pay boost are less likely to turn over consultants the following year.
  • Following the 2009 SEC rule change, companies that switched to specialist consultants including the new boutiques paid their CEOs about 10 per cent more than companies that retained their multi-service consultants.
  • While the 2009 SEC rule change was designed to diminish a potential avenue for management to influence multi-service consultants retained by the board – because all fees had to be disclosed – the change in fact has led to an increase in supplemental compensation-only consultants retained by management, and a 13 per cent CEO pay increase by companies that followed this route.

The paper is authored by Dr Jenny Chu, University Lecturer at Cambridge Judge, Jonathan Faasse, PhD student at the School, and Professor Rau.