Excessive CEO Pay and the Rent Extract hypothesis

Transcription

1 The Role and Effect of Compensation Consultants on CEO Pay Brian Cadman The Wharton School Northwestern University Mary Ellen Carter The Wharton School Stephen Hillegeist INSEAD November 2007 ABSTRACT We examine the effect of compensation consultants on CEO pay. Using a sample of 292 firms in 2006 randomly selected from ExecuComp, we find that compensation consultants are associated with higher salaries, consistent with the hypothesis that consultants help boards of directors justify excessive CEO pay. However, we also find that the use of a consultant is associated with lower bonuses and total compensation. In addition, we find that when consultants are used, CEO pay has greater sensitivity to performance, particularly negative performance, consistent with consultants devising pay schemes that hold CEOs more accountable for poor performance. Finally, we find that compensation committees are more forthcoming in their disclosure of executive pay when a consultant is used. Together our findings suggest that executive pay schemes reflect (more) efficient contracting when consultants are involved in the compensation process. Perhaps as a result, we find that compensation committees provide more details of such pay packages when they have hired a consultant. Overall, our results are more consistent with the efficient contracting hypothesis than with the rent extraction hypothesis. We gratefully acknowledge the financial support of the Alliance Center for Global Research and Development at INSEAD and the Wharton School. We appreciate helpful comments from Katerina Semida. This project involved extensive hand collection of data. We thank Nichole Kim, Cheng Li, Christine Roh, Katerina Semida, Shari Singh and YinYin Yu for their help with this effort.

2 1. Introduction This study examines whether and how compensation consultants influence the level and form of executive pay. While agency theory provides guidance on optimal contracting schemes and prior empirical literature extensively studies contracting design (see for example Core and Guay, 1999 and Hall and Murphy, 2002), little is known about the role of compensation consultants in the design of incentives schemes or how compensation consultants influence executive pay levels. This question has become particularly important as the use of compensation consultants has risen over the past few years (Higgins, 2007). We shed light on this issue by examining the relationship between the use of compensation consultants and the level and design of CEO compensation for a sample of firms from the S&P 1500, which represents the largest publicly traded U.S. firms. Boards of directors and compensation committees are rarely knowledgeable about the economic determinants of optimal compensation design. At the same time, the lack of a generally accepted benchmark for evaluating executive pay packages sets the stage for frequent criticism. For example, Crystal (1991) argues that executive compensation is excessive and insulated from actual performance. As such, boards of directors and compensation committees frequently hire compensation consultants to help guide them through the complex issues regarding executive pay. Stronger governance rules have also caused boards to rely on the advice of independent consultants (Guerrera, 2006). Compensation consultants provide specialized knowledge of executive compensation design on multiple dimensions. They advise the firm regarding accounting and tax regulations that pertain to executive compensation design. In addition, 2

3 compensation consultants often provide information on industry-wide pay practices through survey data and guide the selection of comparable (peer group) firms to aid the firm in setting competitive pay levels. 1 More generally, compensation consultants may help the firm design compensation schemes that more closely align the interests of managers with shareholders. Such a role is consistent with the efficient contracting hypothesis, which states that executive compensation is optimally determined (on average) to maximize shareholder value. Despite the potential benefits of compensation consultants advising the board of directors and compensation committee, some view their role with great suspicion. Critics allege that consultants help disguise and justify excessive executive pay (Bebchuk and Fried, 2006; Crystal, 1991; Morgenson, 2006a). The critics argue that compensation consultants enable executives to extract rents from the firm. For example, consultants may handpick peer groups to help justify higher salaries. Similarly, compensation consultants may help design compensation schemes that provide greater pay without requiring greater performance, potentially by identifying easily attainable targets and/or providing compensation schemes that are not closely linked with performance. According to this view, consultants help executives extract wealth from the firm at the shareholders expense. Such a role is consistent with the rent extraction hypothesis, whereby executives use their power to extract rents from shareholders. The goal of this study is to examine the effect that compensation consultants have on the design of executive compensation packages. Specifically, we examine the association between the use of compensation consultants and executive compensation 1 Many firms in our sample indicate that they set salary at the median or 75 th percentile of the salary from their designated peer group. 3

4 practices, including the level of compensation and the sensitivity of pay to performance. Our findings shed light on the role of compensation consultants in the design of executive compensation plans and provide evidence on whether compensation consultants aid the firm in devising more efficient contracting schemes or whether they enable executives to extract rents from the firm. To address these issues, we utilize the recent disclosure requirement of the compensation committee in the firms proxy statement. Under the new Securities and Exchange Commission rules (effective for filings on or after December 15, 2006), companies must provide a Compensation Disclosure and Analysis (CD&A) section in their annual proxy statement. Among other information, firms must disclose which, if any, compensation consultant the firm retains to advise the compensation committee. Utilizing these disclosures, we hand collect this and other data for a sample of 292 firms randomly selected from the ExecuComp database. 2 Using this sample of firms, we find that 85% use a compensation consultant, suggesting that the use of consultants is widespread. We also find that, of the firms that hire a consultant, the top five consultants represent 70% of the sample. To address the issues described above, we examine the level and design of executive compensation across firms that do and do not retain a compensation consultant. In addition, we test for differences between firms that hire one of the top five consultants and firms that hire another consultant. Our univariate analysis indicates that clients of compensation consultants pay their CEOs higher salaries, bigger bonuses, and provide them with greater amounts of equity, especially when they employ a top five consultant. 2 As discussed further in Section 3, our sample consists of firms randomly selected from the ExecuComp database. We are in the process of hand-collecting data for all December fiscal year end firms on ExecuComp with 2006 data. 4

5 After controlling for other economic determinants of executive pay, we continue to find that the use of a consultant is associated with greater CEO salaries. However, we find that annual bonus payments and total direct compensation are not significantly different for clients of compensation consultants after controlling for economic determinants. The evidence on the relation between compensation consultants and pay-forperformance sensitivity is consistent with the efficient contracting hypothesis. Specifcally, we find that after controlling for performance, clients of compensation consultants pay significantly smaller bonuses, but we find weak evidence that the bonus is more sensitive to return on assets. When we also consider equity payments, we find stronger evidence that clients of compensation consultants (in particular for top five consultants) grant lower values of cash and equity payments. At the same time, we find that total direct compensation is more sensitive to performance for clients of top compensation consultants. We extend our analysis of pay for performance sensitivity (PPS) by allowing the relation to vary for positive and negative performance, as in Gaver and Gaver (1998). The results indicate that the increased sensitivity of compensation to performance for firms that hire consultants is driven by higher PPS for loss making firms; we find no significant differences in PPS based on the use of consultants when return on assets is positive. Overall, our findings suggest that compensation schemes of firms that retain compensation consultants provide greater baseline salaries but also more powerful incentives by more closely linking pay with performance, in particular when performance is poor. This combination suggests that the higher base salaries are compensating CEOs for the additional compensation risk that is imposed on them. 5

6 To further address the issue of whether compensation consultants help executives disguise and justify excessive executive pay, we investigate the level of disclosure in the compensation discussion and analysis. After controlling for a set of disclosure determinants, we find firms that retain a compensation consultant provide longer CD&A reports in the annual proxy statements. This evidence is consistent with clients of compensation consultants providing more thorough discussions of the compensation schemes. Overall our results suggest compensation consultants provide expertise to compensation committees and aid them in setting CEO pay in a manner that more closely aligns the interests of executives with shareholders. We find limited evidence that compensation consultants help justify excessive and inappropriate pay in the form of greater salaries. At the same time, we find that the bonus and total direct compensation (including equity payments) are more sensitive to firm performance, and to negative accounting earnings in particular, when the firm retains a consultant. These results are generally strengthened for clients of top compensation consultants. However, we are continuing to expand our sample and to validate our conclusions and further explore the determinants of equity incentives. We also plan to explore the extent to which the independence of the compensation consultant influences compensation contracts using various independence metrics we have collected from the proxy statements. This study contributes to the compensation and governance literatures on the role of governance and board characteristics in achieving efficient contracting schemes by investigating an important advisor to the board, the compensation consultant. Because of prior limited disclosure, ours is among the first to study the role of compensation 6

7 consultants and the effect they have on executive pay using a broad sample of firms. Our study also provides additional evidence on the more general debate regarding executive compensation practices, which can help distinguish between the rent extraction and efficient contracting hypotheses. Evidence on this debate is important, not least because the controversy has moved to a global forum with non-us executive pay packages coming to resemble their US counterparts (Fabrikant, 2006; Grant et al, 2006). Our paper continues as follows. In Section 2, we provide background information and develop our hypotheses regarding the association between the use of compensation consultants and executive compensation. Section 3 discusses data sources, variable construction, and our research design. Section 4 presents the results of our empirical tests, and Section 5 concludes the paper. 2. Background and hypothesis development 2.1 Background Consultants have been advising firms about executive compensation for several decades. U.S. public companies frequently employ outside consultants to provide input into the executive compensation process. Compensation consultants generally assist compensation committees in two ways. First, they provide expertise on compensationrelated issues. This expertise covers various legal and tax-related aspects of executive compensation practices, as well as pay practices appropriate for organizational changes such as mergers, acquisitions, spinoffs, and restructurings. Consultants have extensive knowledge about recent developments in pay practices and different forms of compensation and benefits. Thus, they can provide expert guidance to the compensation 7

8 committee in tailoring packages for its executives (Brancato, 2002). Second, compensation consultants typically have access through proprietary surveys to more detailed information about industry pay practices than is publicly disclosed. These surveys allow consultants to provide the compensation committees with detailed analyses of peer group compensation practices. Indeed, data from selected peer group firms are frequently used as the starting point for determining compensation packages. 3 However, until recently, there has been little public information available about consultants usage or role within the firm, likely due to the fact that firms were not required to disclose the use of compensation consultants. This lack of transparency has contributed to suspicions about whose interests they really serve: shareholders or executives (Crystal, 1991; Morgenson, 2006a). Critics contend that compensation consultants merely provide justification for overly-lucrative executive pay packages. Compensation consultants can aid the executive in extracting rents by managing survey data and opportunistically selecting peer groups that make their client s performance appear better and their pay packages appear smaller than they actually are (Crystal, 1991). 4 In addition, consultants who are also hired by management to provide other services such as actuarial and other compensation benefits may be under considerable pressure to recommend higher pay packages for executives in order to retain their other, potentially more lucrative, consulting business with the client firm (Creswell, 2007, Morgenson, 2007). 3 Bizjack, Lemmon and Naveen (2007) report that 96 of 100 firms examined used peer groups in determining management compensation. 4 This type of strategic selection of benchmarks has been documented in other settings. Byrd et al. (1998) and Soffer (1998) document that firms strategically select a benchmark to maximize relative performance measures in proxy statements while Schrand and Walther, 2000 find that managers strategically select the prior-period earnings amount that is used as a benchmark to evaluate current-period earnings. 8

9 In response to increased concerns over executive pay, the Securities and Exchange Commission requires companies to provide a Compensation Disclosure and Analysis (CD&A) section in their annual proxy statement. The CD&A requires numerous disclosures by the Compensation Committee, including which, if any, compensation consultant was used in the setting of compensation for top executives. 5 In addition, firms must disclose whether a peer group of firms was used, and if so, name the firms in the peer group. These new disclosures allow us to provide systematic evidence on the role of compensation consultants. 2.2 Hypothesis development The use of compensation consultants can be explained within an optimal contracting framework ( efficient contracting hypothesis ) on the grounds that they contribute useful information and considerable expertise to the design of compensation packages. Shareholders can benefit if using a consultant results in compensation packages for top executives that more closely link executive pay to firm performance compared to the compensation packages that committees acting on their own would have devised. If this characterization of their role is correct, then we expect various properties of executive compensation to be more closely aligned with shareholders interests when firms retain a compensation consultant. It is possible, however, that the true role of compensation consultants is to validate excessive pay packages that are not in shareholders interests ( rent extraction 5 Item 407(e)(3)(iii) of Regulation S-K requires companies to disclose the role compensation consultants played in the decision-making process, and we asked a number of companies to do so. In particular, we asked companies to more specifically disclose the nature and scope of a consultant s assignment and material instructions the company gave it. 9

10 hypothesis ). A CEO that is able to exercise power over the board of directors and the compensation committee has the opportunity to extract additional compensation from the firm. 6 Under this view, compensation committees are either persuaded or provided incentives to recommend excessive compensation. In doing so, they may utilize compensation consultants to justify to shareholders and outsiders the excessive levels of compensation. Hiring compensation consultants provide captive boards with the opportunity to attribute compensation design to the advice of experts and the pay practices of peer firms. Consistent with this argument Wade, Porac and Pollock (1997) find firms that pay their CEOs larger base salaries are more likely to cite the use of consultants and surveys in justifying executive pay to their shareholders. Compensation consultants frequently provide other, and potentially more profitable, services to the client firm beyond advice about executive compensation. In such situations, compensation consultants will lack independence and be less likely to provide objective recommendations. Instead, they are likely to curry the CEO s favor by recommending excessive pay packages in order to secure and protect these other lucrative assignments (Crystal, 1991, Morgenson, 2006a). Such activities can take place even when the compensation committee is composed of truly independent directors who are trying to act in the best interests of shareholders. Consultants can inappropriately influence executive pay through two methods. First, executives are typically evaluated on multiple aspects of firm performance, such as earnings per share, stock returns, sales growth, etc. Consultants can justify higher pay packages by strategically emphasizing those measures of firm performance where the 6 Bebchuk and Fried (2004) provide a thorough description of the rent extraction hypothesis and its supporting arguments. 10

11 firm has performed well (or is more likely to perform well). Second, consultants can opportunistically select the peer groups that are used to calibrate executive pay levels. 7 Compensation consultants can skew the selection of the peer groups toward larger firms and firms with relatively high CEO salaries in order to justify higher pay at the client firm even if the CEOs performance does not warrant it (Gillian, 2001). This effect is particularly strong when compensation committees state (as they frequently do) that they want their CEOs salaries to equal the median amount of a select group of peers against which they compete for executive talent (Morgenson, 2006b). In total, these arguments suggest that the use of consultants will lead to even higher pay packages that are less closely aligned with shareholders interests when firms hire compensation consultants than when firms do not. If the optimal contracting hypothesis is descriptive, then the use of consultants will lead to more efficiently designed pay packages that more closely align executives with shareholders interests. Because salaries are generally fixed payments that do not provide incentives, under the efficient contracting hypothesis, ceteris paribus, CEO salaries will be lower in the presence of compensation consultants. On the other hand, if the rent extraction hypothesis is descriptive, then compensation consultants will be associated with higher salaries. To distinguish between these predictions, we test the following hypothesis: H1: There is a negative (positive) association between CEO salaries and the use of compensation consultants under efficient contracting (rent extraction). 7 While we currently test this issue by examining compensation schemes, we intend to more directly investigate issues associated with peer group selection in future versions. 11

12 This hypothesis also applies to other forms of compensation such as annual bonus and equity payments. However, these other forms of pay are generally associated with performance or incentive targets. To address this issue, we focus the discussion of incentive-related compensation in the following hypothesis. A primary objective of executive compensation is to link executive pay to firm performance, thereby aligning the executive s wealth with shareholders wealth. In order to accomplish this, CEO compensation packages typically include variable cash pay (bonus) and equity-based pay in the form of shares and stock options. These types of compensation schemes increase pay-for-performance sensitivity by more directly linking executive wealth to firm performance. Under the efficient contracting hypothesis, we predict that the presence of a compensation consultant is associated with greater payperformance sensitivity, thereby achieving greater alignment between executives and shareholders. 8 Increased pay-for-performance sensitivity imposes risks on executives and encourages executive effort. However, risk- and effort-averse executives prefer large fixed compensation packages, and variable pay that depends on easily attained targets. To the extent indulged, both preferences will result in compensation that is less sensitive to firm performance than shareholders would prefer. Therefore, compensation consultants that help executives extract rents from the firm may do so by designing 8 Variable pay imposes risks on the CEO since the ultimate payoff depends on firm performance and the performance measure does not perfectly capture effort. As a result, risk-averse CEOs prefer less contingent compensation, ceteris paribus. Ideally, the compensation committee optimally trades-off the incentive benefits of performance-related pay with the costs of imposing risk on the executive. We assume that due the consultant s expertise in this area, firms that employ them are better able to manage this trade-off. Hence, the end result will be higher PPS at firms that engage compensation consultants compared to firms that do not. 12

13 compensation schemes with easily attainable targets, resulting in weaker payperformance sensitivity. The rent extraction hypothesis predicts that CEOs of firms with compensation consultants provide compensation schemes that are less sensitive to firm performance. In contrast, the efficient contracting hypothesis predicts that compensation consultants help the firm design compensation schemes that are more sensitive to performance. To distinguish between these theories, we examine the sensitivity of the annual compensation to firm performance and test the following hypothesis: H2: There is a greater (smaller) association between CEO pay-performance sensitivity and the use of compensation consultants under the optimal contracting (rent extraction) hypothesis. Our final hypothesis examines the relation between compensation consultants and the amount of information disclosed in the compensation disclosure and analysis (CD&A) report. Under the efficient contracting hypothesis, the compensation consultant provides expertise in designing a compensation scheme that benefits shareholders. Accordingly, we predict that the compensation committee chooses to provide more information in the CD&A regarding the nature and design of executive compensation when they are advised by a consultant. Alternatively, if the compensation committee aids in executive rent extraction, we predict that the compensation committee will be less forthcoming in the CD&A about the details of the compensation contract. Less information will likely help shield them from criticism by shareholders and other outsiders. We measure the degree to which the compensation committee is forthcoming 13

14 about executive compensation (or the quantity of information disclosed in the CD&A) as the number of words in the CD&A. Using this proxy, we test the following hypothesis: H3: The quantity of information disclosed in the CD&A is positively (negatively) associated with the use of compensation consultants under the optimal contracting (rent extraction) hypothesis. 3. Research Design 3.1 Sample selection and data sources Our initial sample consists of 371 firms in the S&P 1500 randomly selected from ExecuComp. Because the new Compensation Disclosure and Analysis requirement was effective for filings on or after December 15, 2006, our sample is approximately onethird of ExecuComp firms with December fiscal year ends. We begin with one-third of ExecuComp firms since our analysis requires extensive hand-collection of data. 9 Of these 371 firms, 12 are missing proxy statements for 2006, 64 do not have executive compensation data on ExecuComp, and three are missing market value of equity. Thus, our final sample consists of 292 firms. From firms CD&A disclosures in the 2006 proxy statements, we determine what, if any, compensation consultant the firm retains. We also collect information on the degree of participation by the CEO in setting pay. Finally, from these proxy statements, 9 We are currently in the process of expanding the sample to all ExecuComp December fiscal year end firms with compensation data in

15 we collect the size of the compensation committee, the number of times it met during the year, and the total number of words in the CD&A. 10 We obtain performance data, firm size, and the market to book ratio from Compustat and CRSP. We obtain CEO compensation data from ExecuComp. As reported in Table 1 Panel A, our sample firms are generally profitable with an average ROA of 5.3% in In addition, these firms have average book-to-market of As reported in Table 1 Panel B, our sample firms are somewhat concentrated in durable manufacturers (21%), financial institutions (18%) and utilities (10%). No other industry group comprises more than 10% of sample firms. As reported in Table 1 Panel C, approximately 85% (247 firms) of the sample reported using a compensation consultant in Of these firms, 70% (171) use one of five main consultants: Towers Perrin (the consultant employed by the largest percent of the sample), Mercer Human Resources Consulting, Hewitt Associates, Frederick W. Cook, and Watson Wyatt. This distribution is consistent with that of a study of Russell 3000 firms by the Corporate Library (Higgins, 2007) and suggests that our results can be generalized to a larger population of firms. 3.2 Research design For all of the tests that follow, since there is some concentration in our sample among five compensation consultants, we measure an indicator for clients of other consultants (OTHER_CONSULT) and an indicator variable that captures whether the firm uses one of the top five consultants (TOP_CONSULT). This distinction provides 10 We intend to further explore the governance characteristics relating the independence of the board, compensation committee, and committee meetings in future work. 15

16 us the opportunity to refine our tests and determine the extent to which there are differences amongst the two groups of consultants. In particular, the largest consultants may be more likely to offer additional services (actuarial or benefits outsourcing) that the client firms may also be utilizing. To the extent this is true and it compromises their executive pay services, we may expect different results for these consultants. To examine the question of whether firms use of compensation consultants increases CEO pay, we estimate the following OLS model for our sample of firms in 2006: COMPENSATION j = α 0 + α 1 ASSETS j + α 2 BM j + α 3 ROA j + β 1 TOP_CONSULT j + β 2 OTHER_CONSULT j + Σ α i IND j + ε j (1) where: COMPENSATION j = CEO Salary (ExecuComp variable Salary) for firm j in 2006, or CEO bonus (ExecuComp variable bonus and noneq_incent) for firm j, or total compensation (the sum of cash pay and the fair value of stock and option grants); TOP_CONSULT = 1 if firm j employs a one of the consultants that are in the top 5 of the market share in our sample in 2006, 0 otherwise; OTHER_CONSULT = 1 if firm j employs a compensation consultant, but not one of the Top 5 in 2006, 0 otherwise; ASSETS j = Log of total assets (Compustat Data Item 6) of firm j in 2006; BM j = Book value of common equity (Compustat Data Item 6 Compustat Data Item 181 Compustat Data Item 130) divided by market value of equity (Compustat Data Item 25 * Compustat Data Item 199) of firm j in 2006; ROA j = Return on assets (Compustat Data Item 172 / Compustat Data Item 6) of firm j in 2006; IND j = Indicator variable for industries based on Barth et al (1998). We include variables to capture the standard economic determinants of compensation: the log of total assets to control for firm size effects, the book-to-market ratio to control for growth opportunities, and return on assets to control for firm performance (Smith and Watts, 1992; Gaver and Gaver, 1993 and 1995; Core et al., 16

17 1999). We include industry indicator variables using the classification from Barth, Beaver, and Landsman (1998) to capture potential differences in compensation practices across industries. If the use of a compensation consultant leads to higher CEO pay, we expect β 1 and β 2 to be positive. Also, to the extent that the top five consultants exacerbate the executive s abilities to extract rents form the firm through increased salaries, we would expect β 2 > β 1. At the same time, negative coefficients on the consultant indicators would be consistent with the presence of compensation consultants being associated with lower levels of compensation. Similarly, finding that β 2 < β 1 would suggest that firms with top consultants provide lower pay than clients of other consultants. While estimating the model above provides insight into the level of compensation granted to the CEO, it does not shed light on the issue that compensation consultants may help the firm provide compensation that is more sensitive to performance. To examine the relation between firms use of compensation consultants and pay-for-performance sensitivity, we estimate the following OLS model of the relation between accounting performance and bonus compensation 11 : COMPENSATION j = α 0 + α 1 ASSETS j + α 2 BM j + α 3 ROA j + β 1 TOP_CONSULT j + β 2 OTHER_CONSULT j + β 3 TOP_CONSULT j *ROA j + β 4 OTHER_CONSULT j *ROA j (2) + Σα i IND j + ε j Where the variables are as defined in Eq. (1). Positive coefficients on the interaction of consultant with ROA (β 3 and β 4 ) are consistent with the use of a compensation consultant leading to greater pay-for- 11 Murphy (2000) finds that 91% of firms in his sample use accounting earnings as a performance measures in bonus contracts hence we use return on assets as our performance measure. 17

18 performance sensitivity. If consultants aid the executive in extracting rents, we would expect to find no relation on the interaction of consultant and performance. In addition, the rent extraction hypothesis predicts that the compensation level is significantly larger (β 1 > 0 and β 2 >0) after controlling for performance. In addition, investigating the difference between β 3 and β 4 provides evidence on the difference in the pay-forperformance sensitivity across the consultant types. We also estimate this model allowing for separate effects of positive and negative performance following Gaver and Gaver (1998). That is, we estimate the model with separate variables for positive performance (POS_ROA) and negative performance (NEG_ROA) including separate interactions with the consultant indicators. If compensation consultants design contracts with less pay-performance sensitivity, it may be the case that such contracts either reward good performance less (in which case we expect a negative relation on the interaction of CONSULTANT and POS_ROA) or penalize bad performance less (in which case we expect a negative relation on the interaction of CONSULTANT and NEG_ROA). Alternatively, positive relations would be consistent with clients of compensation consultants providing greater sensitivity of pay-for-performance. Finally, to examine whether the use of compensation consultants leads firms to be less forthcoming in their disclosures about executive compensation and test hypothesis 3, we estimate the following regression: WORD j = α 0 + α 1 NO_EXEC j + α 2 PENSION j + β 1 TOP_CONSULT j + β 2 OTHER_CONSULT j + Σα i IND j + ε j (3) where all other variables are defined as before and: 18

19 WORD j = The number of words in the CD&A for firm j in 2006; NO_EXEC j = The number of executives included in the Summary Compensation table of the proxy statement for firm j in 2006; PENSION j = 1 if compensation for executives in firm j include a pension in 2006, 0 otherwise; We include NO_EXEC and PENSION to control for other determinants of increased discussion in the CD&A since more executives will require more explanation and pensions have additional required disclosures. Positive coefficients on the consultant indicators are consistent with consultants being associated with compensation discussion and analyses that are more forthcoming. In addition, comparing the coefficients on the types of consultants provides evidence on the differing relations across the consultant types. 4. Results 4.1 Univariate analysis Our first evidence on the relation between compensation levels and the presence of compensation consultants is reported in Table 2, which reports the summary statistics of the annual compensation for our sample of firms. 12 We find that average CEO of clients that retain a compensation consultant earn higher salaries than firms that do not retain a compensation consultant. We also find that CEOs of firms that retain a top consultant earn significantly higher salaries. We do not find a significant difference in the mean bonus paid to the CEO of firms that retain other consultants relative to firms 12 For parity we focus our univariate analysis on the difference between clients of top consultants clients of other consultants, and firms that do not retain a consultant. In general, we find similar trends when we compare firms that retain any consultant to those that do not retain a consultant, but the differences are less significant because the sample of firms that do not retain a consultant is significantly smaller than those that do. Our multivariate analysis further explores this issue. 19

20 that do not retain a consultant. However, we find a significant difference in the median bonus between the two samples. In addition, we find that clients of top consultants earn significantly greater bonuses than both clients of other consultants and firms that do not retain a consultant. We find similar results as those of bonus compensation when we consider total cash compensation. When we consider total compensation including equity payments, we find that clients of compensation consultants earn significantly greater total compensation than firms that do not retain a consultant on average. However, we do not find a significant difference in total compensation between the clients of top consultants, and clients of other consultants. Interestingly, when we separately identify the components of equity compensation, we find that the stock compensation is significantly greater for firms that retain a compensation consultant compared with firms that do not retain a consultant. There is no significant difference between the stock compensation for clients of the top consultants compared with clients of other consultants. At the same time, we do not find a significant difference in the stock option compensation between clients of other consultants and firms that do not retain a consultant. While we find that clients of top consultants grant significantly greater option compensation than clients of other consultants and firms that do not retain a consultant, we do not find that clients of other consultants grant more options than firms that do not retain a consultant. Overall, the results of our univariate analysis suggest that compensation consultants help executives earn larger pay packages and clients of the top 5 consultants earn somewhat larger cash compensation than clients of other consultants. However, we are hesitant to make broad conclusions from the univariate analysis because the summary 20

21 statistics neither control for important economic determinants of compensation, nor provide evidence on the sensitivity of the compensation to performance. 4.2 Multivariate analysis To more directly test hypothesis 1 and 2, and provide evidence on how compensation consultants influence the level compensation as well as the sensitivity of compensation to performance, we estimate executive salaries as a function of economic determinants and the presence of a compensation consultants. In addition, to distinguish the influence of Top consultants from other compensation consultants, we separately identify clients of the difference groups of consultants as described in Eq. (1). By examining the influence of the five largest consultants in the market, we are able to infer whether the relations differ for consultants that hold greater shares of the market. Table 3 provides estimation results of the level and sensitivity of various measures of compensation. Column 1 provides evidence on the relation between compensation consultants and salary. The positive and significant coefficients on OTHER_CONSULT and TOP_CONSULT are consistent with clients of consultants paying significantly greater salaries than firms that do not retain a consultant. We do not find a significant difference in salaries across the two consultant groups as suggested by an F-test of β 1 = β 2. To provide evidence on the pay-for performance sensitivity of salary, Column (2) provides results from testing whether the relation between salary and performance is different for clients of compensation consultants. After allowing the salary to vary with performance, we no longer find that compensation consultants (regardless of type) provide greater salaries. However, we find some evidence that the 21

22 relation between salary and performance is greater for clients of top consultants than clients of other consultants. Columns 3 and 4 report results of the analysis where the annual bonus is the dependent variable. Here we do not find evidence that clients of consultants provide significantly different bonuses than other firms. In addition, we do not find evidence that clients of top consultants pay their executives different bonuses than clients of other consultants. However, after controlling for performance and allowing the relation to vary for clients of consultants, we find firms that retain a compensation consultant grant significantly lower bonuses than other firms (as indicated by an F-test that β 1 + β 1 <0). In addition, we find that clients of top consultants provide significantly lower bonuses than firms that hire other consultants. We do not find evidence that the bonus is more sensitive to performance for firms that retain either type of consultant. In aggregate, the results of the bonus analysis provide weak evidence that clients of compensation consultants grant lower bonuses than other firms. We find similar results to the analysis of bonus compensation when we consider total cash compensation suggesting (consistent with the summary statistics) that bonus is a larger component of cash compensation, and this appears to be driving the results of the total cash compensation results. The last two columns of Table 3 present results from estimating the total compensation including equity payments. To address the concern that equity is granted in part to realign executive incentives with levels predicted by economic determinants as suggested by Core and Guay (1999), we control for the residual incentives held in the executive portfolio at the end of the prior fiscal year. Interestingly, after controlling for economic determinants of annual compensation, we do not find that clients of 22

23 compensation consultants provide significantly different levels of total compensation. However, after allowing the relation between total compensation and performance to vary for the different groups of firms, we find that clients of top consultants earn lower levels of total compensation, but the compensation is significantly more sensitive to performance. In addition, we find that the sensitivity of total compensation to performance is significantly more sensitive for clients of compensation consultants of either type (as suggested by an F-test of β 3 +β 4 =0). We also find that clients of top consultants provide total compensation levels that are significantly more sensitive to firm performance than clients of other consultants. 4.3 Positive and negative performance Gaver and Gaver (1998) find that the sensitivity of compensation to performance differs for positive and negative performance. To address this issue and further investigate the sensitivity of compensation to performance in the presence of compensation consultants, we estimate the models described above allowing the coefficients for performance to vary for positive and negative ROA. Table 4 presents results of the expanded estimations. In general the results on salary are slightly weaker in that we no longer find a difference in the relation between salary and performance for clients of the different consultants. However, turning to the bonus compensation, we find that clients of top consultants pay bonuses that are significantly more sensitive to negative performance than other firms (and clients of other consultants). The results suggest that the significantly greater sensitivity of bonus to performance found in Table 3 is a result of the 23

24 increased sensitivity to negative performance. Again when we consider total cash compensation, the results are consistent with those found for the bonus relations. Finally, when we consider the equity payments in conjunction with the cash pay after allowing the relation on performance to vary for positive and negative returns, we find that clients of other consultants grant significantly greater compensation than clients of top consultants. We also find that clients of consultants grant annual compensation that is more sensitive to performance, when the performance is negative. At the same time, we find that clients of top consultants grant annual compensation that is more sensitive to performance, when the earnings are positive, than clients of other consultants. Overall, the results after allowing the relation to vary for positive and negative earnings are broadly consistent with the main findings. However, the evidence suggests that the increase in pay-for-performance sensitivity is primarily focused on cases where earnings are less than zero, and less associated performance once the earnings are positive. This finding is consistent with Gaver and Gaver s (1998) conjecture and finding of an asymmetric relation between compensation and accounting performance. 4.4 CD&A disclosure Our final hypothesis relates the level of disclosure regarding compensation to the presence of a compensation consultant. If the use of a compensation consultant leads to more efficient compensation contracts, compensation committees are likely to be more forthcoming about its contracts with executives. Thus, we estimate the influence of compensation consultants using the word count of the compensation discussion and analysis (CD&A) of the annual proxy statement as a measure of the degree to which the 24

25 firm is forthcoming about their compensation. Because firms with more named executives and with executive pensions will likely have longer CD&As, we control for these two elements in the estimation. The results of the estimation are provided in Table 5. We find evidence that clients of compensation consultants and top compensation consultants present longer CD&As. In addition, we find that the clients of top compensation consultants provide CD&As with significantly more words than clients of other compensation consultants. Overall, the evidence suggests that firms that retain compensation consultants are more forthcoming about their compensation, and clients of top consultants are less forthcoming that clients of other consultants. 4.4 Future direction We are collecting information on the use of consultants in the remaining sample of 594 firms on ExecuComp with December fiscal year ends. We are also in the process of hand-collecting compensation data for the 64 firms we were not able to include in the current analysis. In the next version of this paper, we plan to include all 965 firms in our analysis. In addition, we are collecting data on the types of performance measures used to determine bonus compensation. We intend to examine whether the use of compensation consultants is correlated with the use of a performance measure which had better outcomes in prior years. Finally, we have collected data on the size of the compensation committee and the number of times the committee met in We intend to incorporate this data in the next version of the paper to consider the substitutive or complementary role the compensation committee plays, relative to the compensation consultants, in setting CEO pay. 25

26 5. Conclusions We examine the effect that compensation consultants have on the design of executive compensation packages. Little is known about the role of compensation committees in the design of optimal incentives schemes or how the assistance of compensation consultants influences executive pay. Understanding the influence of consultants has become a particularly important question as the use of compensation consultants, both domestically and internationally, has risen over the past few years (Higgins, 2007). The dominant theories about how executive compensation is determined suggest two very different roles for the compensation consultant. Under the optimal contracting hypothesis, compensation consultants will assist the firm in designing compensation schemes that more closely align the interests of managers with shareholders due to their specialized knowledge of compensation practices. Under the rent extraction hypothesis, consultants are retained to help secure and justify excessive pay schemes that serve to transfer wealth from shareholders to executives. Our analysis of the role of compensation consultants provides evidence on which theory is more descriptive in practice. Taking advantage of new SEC disclosures that require companies to disclose whether the firm retains a compensation consultant, we identify which firms use a compensation consultant for a sample of 292 firms randomly selected from the ExecuComp database. We find that 85% of the firms in our sample employ at least one compensation consultant, suggesting that the use of consultants is widespread. We then examine the relation between the level and form of CEO pay and the use of a 26

27 compensation consultant. Specifically, we consider salary, bonus and total compensation, and we examine the pay-for-performance sensitivity of CEO pay. We find that the use of a consultant is associated with higher CEO salaries but lower annual bonus payments and lower total direct compensation, after controlling for economic determinants of compensation. These results provide mixed evidence in support of the efficient contracting hypothesis. However, we find that the annual bonus and total direct compensation (which includes equity payments) is more sensitive to firm performance for firms using compensation consultants than for firms that do not. In particular, we find that these contracts are more sensitive to negative performance than positive performance, consistent with consultants devising pay schemes that hold CEOs more accountable for poor performance. Overall, our findings suggest that the compensation schemes of firms that retain compensation consultants provide greater baseline salaries, while also providing greater incentives in the form of higher PPS. To further address the issue of whether compensation consultants help executives disguise and justify excessive executive pay, we investigate the level of disclosure in the CD&A report. After controlling for a set of disclosure determinants, we find firms that retain a compensation consultant provide more thorough CD&A reports in the annual proxy statements. In total, these results suggest that executive pay schemes reflect efficient contracting when consultants are used and, as a result, compensation committees are willing to provide more details of such pay packages. 27

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