It’s standard practice for North American companies to compensate their CEOs with an annual bonus incentive for increasing profits and to continue to boost their companies’ share price. It’s a “job well done” handshake for their hard work overseeing the company’s strategy and operations.
But what is the fair way to judge whether the CEO should be compensated, and, if so, how much compensation should be given?
Ivey Assistant Professor Frank Li, who conducts research in the field of empirical corporate finance, with a focus on corporate governance and executive compensation, researched approximately 2,000 of the largest U.S. companies over a period of 10 years “studying executive compensation mechanisms.”
“What we found is that, a very popular method of CEO compensation is one that’s linked to their company’s performance relative to other competing firms’ performance,” says Li.
Relative Performance Evaluation (RPE)
Li and his colleagues found the most fail-safe compensation method, and one being used by 50 per cent of the companies studied for their research, is Relative Performance Evaluation or RPE. Broadly defined, RPE is an evaluation of an individual’s performance relative to a peer group of comparable individuals.
With RPE, the CEO’s company stock performance over the next three to five years will be benchmarked against their competitors: companies of comparable size, riskiness and within the same industry. These companies, most often seven, are chosen by the Board of Directors. If the CEO’s company is ranked first in stock performance among the seven other companies, the CEO receives what Li calls “a huge bonus” – possibly tens of millions of dollars as an annual award.
“If you beat most of them, you will still get a big bonus. But if you beat only one or two then you will get very little bonus. Or, if you can’t beat anyone you may be fired,” he theorizes.
While the idea behind RPE is that an individual shouldn’t be held responsible for risks and factors beyond his or her control, the other side of the coin is that with RPE, it is harder for the individual to influence the outcome, i.e., the ranking in the peer group by, for example, simply manipulating financial earnings.
Before the RPE system became popular (Li says few companies used it 20 years ago), compensation contracts were based on fixed targets. For example, if the company’s net income exceeded $1 billion, the CEO would get a bonus. This fixed target would be easier to beat, just barely, through fraudulent accounting or other illegal or unethical means. But you can’t influence the stock market numbers, especially other peer firms’ numbers, making RPE a much more failsafe method of evaluation.
Examples and fairness
Li says RPE is used in many other ways. He uses his own teaching as an example.
“With my students, I bell their grades relative to their peers in the same class. So, we use relative performance to evaluate students. There is some fairness in this because I may give a very difficult exam while another prof gives an easier exam, if we don’t use RPE, it is not fair for my students who are punished by bad luck of having me as their prof.”
There’s a similar fairness to companies using this assessment for CEO compensation.
“Academically, we say this kind of system – RPE – is a way to filter out shocks to a firm’s performance that are outside of control of their executive officers.”
For example, the government may implement regulations that impact your industry negatively, which lowers the value of your stock and those of your industry peers as well. Because your company is evaluated against these peers, this creates more fairness in this evaluation process. That is, the CEO isn’t penalized for something beyond his or her control.
Li says the next step in this research will be to see whether compensation contracts could be linked to corporate social performance, in addition to corporate financial performance.