How to design your peer group for compensation benchmarking
Given the scrutiny on executive compensation in recent years, it is critical to make sure that your company’s executive pay reflects its performance and aligns with the market. Therefore, it is essential for companies to have an appropriate peer group for performance benchmarking, compensation program design and other compensation decisions.
There are two types of peer groups companies should consider: compensation peer group and performance peer group. Compensation peer group is used as an input to design short- and long-term pay programs, to determine base salary ranges, annual incentive targets and long-term incentive award mix, to assess the competitiveness of total direct compensation awarded to executives, and sometimes, to assess the talent and recruitment practices. The performance peer group is used to measure the company’s relative performance to determine the payout of awards, typically long-term incentives. Whether a company uses only the compensation peer group or both compensation and performance peer group, it is important that the company select the appropriate criteria to form a peer group that reflects the company’s business.
How to select an appropriate peer group
Firstly, the company should start with a group of direct competitors in their sub-industry, using the Standard & Poor’s Global Industry Classification Standard. After this step, it is also useful to look at the peers of these competitors (peers of peers) since they will most likely compete with the company in some ways. However, this practice can lead to industry-wide executive compensation levels being dependent on companies referencing each other, creating a “vicious-cycle” where it is difficult to crack down the high compensation levels in perpetually overpaying industries.
Next, the company should extend its search to the related industries or the general industry to gather a list of companies which has operationally similar business models and might compete with the company for talents.
These potential peers should then be refined by size, which can be market capitalization, total revenue or, in case of financial services companies, asset base. These peers should fall into an appropriate range in terms of size, typically 0.5 to 2 times the size of the company, to be a suitable comparator. Having several “too large” companies compared to your own in the peer group may lead to executive compensation being inflated since larger companies tend to grant larger amount of pay. The opposite holds true when peer companies used are “too small.”
The peers can also be refined further by country, number of employees, EBITDA, and/or other financial metrics. Unsuitable companies should be removed from the list and the company would end up with an appropriate peer group for compensation decision-making. If the list is too small for any meaningful comparison, the company can expand the search to include companies outside of the company’s industry, refine them using the criteria mentioned above and add them to the first list of peers. The final peer group should generally consist of 12 to 20 companies.
How often should you review?
This peer group should be reviewed annually to ensure it remains appropriate, especially when the company or its peers have gone through major mergers, acquisitions, and divestitures. The company will have to re-evaluate its current peers in terms of industry fit and size in order to determine their appropriateness and subsequently replace some peers or add new peers if necessary.
How to compose your performance peer group
The steps in composing a performance peer group is like that of compensation peer group. The company can choose to use the same compensation peer group for performance evaluation. However, since relative performance is often measured over a period, M&A activities within the peer group may create issue for performance comparison. Therefore, the company should consider using an index as a comparator given its dynamic nature. The index could be a broader index of which the company is a part, such as the S&P 500, or a sub-index of which the company is a part, such as S&P 500 Financials, S&P 1500 Media, etc.
Takeaways on Peer Groups
Peer group selection is an important but often challenging part of the executive compensation process. Given the close attention to executive compensation from investors, regulators, and the public as well as the increase in transparency of disclosure, companies should be mindful when choosing the criteria used in selecting peers. A good peer group used in compensation benchmarking will establish executive compensation that aligns with the market and reward high performing executives, rather than rent-seeking ones. Nevertheless, companies should realize that there is no “perfect-match” for peers. Hence, companies should try their best to compose a peer group that reflects their business as closely as possible to ensure the appropriateness of any compensation benchmarking resulting from such peer group and ultimately, the appropriateness of the executive compensation.