Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts

Abstract

This study examines the explicit use of relative performance evaluation (RPE) in executive compensation contracts and the selection of RPE peers. Using S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules, we find that about 25 percent of our sample firms explicitly use RPE in setting executive compensation. We demonstrate that a lack of knowledge of both actual peer-group composition and the link between RPE-based performance targets and future peer performance significantly hinder the traditional implicit test from detecting RPE use. We also find that firms consider both costs and benefits of RPE as an incentive mechanism when deciding to use RPE. Finally, both efficient contracting and rent extraction considerations influence RPE peer selection, with the relative importance of these competing considerations depending on RPE firms’ performance.

The Moderating Effect of Relative Performance Evaluation on the Risk Incentive Properties of Executives’ Equity Portfolios

“…First, the sheer amount of time required to hand‐collect RPE information encourages a narrow sample, as hand collection involves reading the CD&A section of each proxy statement. Second, collecting RPE data for S&P 1500 firms in 2007 enables us to check the validity of our data by comparing our sample statistics with those of Gong, Li, and Shin [] (who also collected RPE data for S&P 1500 firms in 2007). And, third, most firms’ RPE use is time invariant…”

“…We identify firms that use RPE in determining CEO compensation by examining the CD&A section of proxy statements in the SEC EDGAR database. As in Gong, Li, and Shin [], we define a firm as an RPE firm if it provides detailed information on its use of RPE in determining its CEO's compensation (e.g., by describing a specific formulaic RPE plan); otherwise we identify it as a non‐RPE firm. For instance, if a firm merely states that it may use relative performance measures, among others, to evaluate its CEO, then we code it as a non‐RPE firm.…”

“…In order to empirically test our hypotheses, we construct a cross‐sectional sample that consists of all firms in the S&P 1500 index with data availability for fiscal year 2007. We identify firms that use RPE in their executive compensation contracts, based on their disclosure of explicit RPE usage in the CD&A (Compensation Discussion & Analysis) section of their proxy statements, as in Gong, Li, and Shin [].…”

“…Second, we contribute to the RPE literature. The mainstream RPE literature's underlying motivation is contractual efficiency, as posited by agency theory (e.g., Holmstrom [], Antle and Smith [], Lambert [], Garvey and Milbourn [, ], Rajgopal, Shevlin, and Zamora [], Albuquerque [, ], Gong, Li, and Shin []). That is, RPE is intended to reduce uncontrollable risk to the agent (e.g., systematic risk in our study) and hence the cost of executive compensation to the principal.…”

When Feedback Interventions Backfire: Why Higher Performance Feedback May Result in Lower Self‐Perceived Competence and Satisfaction with Performance

“…CEOs and other executives (Gong, Li, & Shin, ), lower‐level managers (Goffin et al, ), and even students (Goubeaud, ) are often evaluated in relative ways. When individuals are evaluated relatively, each appraisee typically has access to three pieces of information: absolute performance feedback (i.e., individual performance), the distribution mean of everyone's absolute performance feedback (i.e., average of everyone's performance), and relative performance feedback (i.e., standing compared to others).…”