When company boards of directors set executive compensation, they often benchmark against peers to determine the appropriate pay levels. Unfortunately, as this Business Week article by Zachary R. Mider and Jeff Green indicates, many firms choose "peers" that are much larger than them. Bigger firms tend to pay their executives higher salaries. Thus, choosing to benchmark against bigger companies creates heftier pay packages. For instance, the authors report that:
Setting the CEO’s salary is one of the most important duties of a public company’s board. So CBS (CBS)
directors decided to give Chief Executive Officer Leslie Moonves a
$69.9 million pay package last year only after assessing the competitive
market for senior executive talent. The board of directors, however,
looked at companies that are, on average, more than twice as large as
CBS and included many in businesses far afield from media.
CBS is not alone though. The practice appears pervasive in publicly held corporations. According to the authors, four of five academic studies that they found on this subject demonstrated evidence of bias in the selection of peer groups by boards of directors. Why do directors build these clearly biased peer groups? They want to stay in the good graces of the CEO, and they are often executives themselves... and would like similar treatment when their compensation packages are set.