Shareholders want a clear understanding of the processes involved in setting compensation levels for top executives, including how decisions are made around the level of pay, compensation programme design and performance assessment. As these decisions increasingly fall under the microscope of shareholder scrutiny, peer group selection for public companies has been questioned as a contributing factor to escalating pay levels. This increased scrutiny has led the US Securities and Exchange Commission (SEC) to adopt more comprehensive disclosure rules. The new rules require more transparency regarding peer groups used to assess competitive practices as part of the executive remuneration disclosure requirements or the Compensation Discussion and Analysis (CD&A) report.

We anticipate that any disclosure rules adopted in the US will ultimately be adopted to various degrees across Europe. In this environment, companies need to be ready to explain and defend their reasons for choosing one set of peers over another.

This Perspective outlines the factors that support effective peer group selection for pay evaluation and recommends key considerations for developing an appropriate and defensible peer group. When properly managed, peer group selection can become a foundation of compensation evaluation, grounding executive pay decisions in fact based data and providing insight into external practices.

In this issue, you will find answers to:

• What is the purpose of having various different peer groups?
• How should organisations screen for the most appropriate peers?
• How many companies should be included in a peer group?  
• How do organisations address peer group challenges?
• How do organisations ensure that multiple peer groups are used responsibly?
• How frequently should an organisation review its peer groups?

Purpose of peers

The composition of a peer group is heavily influenced by its purpose. Peer groups are typically used for three purposes:

• Pay size – What salary, benefits and incentive award levels are competitive?
  Companies determining pay level look at competitive practices related to overall pay delivery, base salaries, annual and long-term incentive targets/payouts and executive benefits.

• Pay practices – How do other companies structure their compensation
  programmes?
  An assessment of the design attributes of other organisations’ incentive plans can provide perspective on performance measurement practices and linkages between pay and performance. Examples of pay practices include pay mix, target, threshold and maximum bonus payout opportunities against performance levels, performance measures used in determining plan payout, weightings of measures, the mix of long-term incentive vehicles and change in control practices.

• Performance comparison – Is pay aligned with performance?
  Peer evaluation can help determine if the amount a company pays executives is
  appropriately aligned with results. When comparing performance relative to peers, companies can not only assess how pay is directionally aligned with performance, but also incorporate this information into the goalsetting process for annual and long-term incentives, or directly use relative performance measurement in incentive plan award calculations.

Regardless of the purpose, peer group research is just one input into the compensation decision-making process. Careful judgement must be applied in analysing and interpreting peer group data to ensure that compensation
decisions appropriately reflect each organisation’s unique business context. In addition, publicly disclosed compensation information is only available for a handful of executive positions. To ensure a consistent approach to assessing pay practices across the entire executive group,
companies will want to supplement peer group research with data from other sources, such as published compensation surveys. 

Screening for peers

Ideally, this is an evaluation process with several steps to identify the most appropriate comparison group.

“Careful judgement must be applied in analysing and interpreting peer group data to ensure that compensation decisions appropriately reflect each organisation’s unique business context.”

1. Identifying market competitors

Screening for peers requires clear analysis to ensure there is a defensible, fact-based group that will support compensation decision making. Initial screening should identify companies that operate in the markets in which a company competes:

• Customer markets

These are typically other organisations in the same industry with whom a company directly competes for customers and revenue. For example, these organisations may fall in a similar Standard Industry Classification (SIC) code and be the primary product competitors in the market. They may also be companies that may not
be in the same line of business, but provide similar products or services. For example, a radio station’s competitors for customers may include other broadcasting companies as well as web-based services that offer regular downloads of music and news.

• Labour markets

These are companies with which the organisation competes for executive talent. They may be organisations from which executives are recruited or to which executives have been lost.

• Capital markets

These include the companies that the organisation competes with for equity or other capital, reflecting comparable financial characteristics. These companies may be identified by utilising analyst or bond rating reports or analysing relative share price movement to determine which other companies investors view similarly.

This perspective will provide validation that the performance characteristics of companies are similar and, therefore, form the foundation for evaluating the alignment of pay with performance.

These markets in most cases overlap – so, the same companies may be competitors for customers, labour and capital. In other cases, these markets are more distinct. Considering multiple perspectives is critical to capture the risk that executives manage – including financial, operational, capital and labour. Compensation programmes and practices reflect these aspects of enterprise risk, which vary significantly among different industries.

For example, industries such as entertainment or financial services typically experience more volatile performance (and risk) than industries like utilities. Reflecting these characteristics, pay levels and incentive use in the entertainment and financial services industries are much more significant than in utilities. Selecting peers that share common profiles helps support fact-based decisions that appropriately reflect this context and will be reasonable benchmarks for evaluating pay and its alignment with performance.

2. Size as a gauge for complexity

Once common competitors for customers, talent and capital are identified, the peers should next be screened for similar business complexity. When it comes to executive compensation, there is a clear correlation between pay level and company size: larger companies tend to manage more capital and have more complex operations, which increases the job scope and responsibility associated with top executive positions.

For most industries, revenue size is an indicator for complexity; for some, like the financial services industry, assets are a more relevant determinant of complexity. While companies sometimes look to market capitalisation as a criterion for identifying comparably sized peers, market capitalisation can be highly volatile and, in our view, should not be used as a primary screen (see “Market capitalisation as a measure for sizing comparators” for more information).

Typically in Europe, for every doubling of revenue or assets, executive total compensation pay levels are correspondingly 16 percent higher. (Salary levels are typically 10% higher and total compensation levels are typically 16% higher. However this varies across industries and countries. Source: Mercer Executive Compensation Database 2006). Given this correlation, appropriate peers should be approximately one-half to two times the size of the company for which peers are being developed. While these guidelines should be balanced against other important inputs such as business character, companies should choose a group of comparators that have the same approximate size at the median. In other words, approximately half of the peers should be larger and half should be smaller.

3. Performance should not be used as a screen

In our view, performance should generally not be used to screen for peers. Using “high performance” as a criterion for selecting peers opens the process up to criticism for “cherry picking” higher paying organisations and may also lead to significant volatility in the group year to year. However, performance may be considered when determining how to position actual pay levels against a group of peers. For example, a company might design its incentive plan to deliver payouts in the upper quartile relative to peers when upper-quartile performance is achieved, while lower levels of performance should result in lower payouts.

In addition, it may be appropriate to consider financial results to understand better the operating character of the potential peers. For example, analysing capital intensity ratios, profitability ratios or valuation ratios (such as P/E, price/earnings) may help isolate peers with similar business models or those that investors value similarly.

What's the magic number

There are situations where there are not sufficient direct peers to develop a robust group. For example, consolidated industries like Integrated Oil and car manufacturing offer a relatively small universe of comparable companies, as do smaller geographic markets such as the Netherlands or Ireland. In cases where there are only a few peers of similar size within an industry, companies will need to broaden their peer groups or consider using multiple reference groups, as discussed below.

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