Follow the Money: Executive Compensation Consultants and the Correlation With Higher Pay

This sounds like one of those 'tell me something I didn't know' stories. Corporate boards hire compensation consultants who - surprise! - discover that their CEO is underpaid and almost certainly about to leave, rendering the enterprise in question a casualty of the war for talent.

Or at least that is the story that corporate executives and their boards like to retail for pubic consumption.

Concerns about the role of compensation consultants have been evident for years. What's different this time is that there is now statistical evidence to support that contention that consultants understand that their role is to justify pay hikes, not to provide an independent assessment.

Not that anyone expects embarrassment and humility to ensue anytime soon, but just as Wall Street's excesses led to eventual heightening of regulation, so, too, will an accumulation of analyses detailing executive pay abuses eventually lead to a change in climate for compensation. But don't start holding your breath just yet. JL

The Economist reports:

Study finds strong empirical evidence for the hiring of compensation consultants as a justification device for higher executive pay.
IF YOU want independent advice, don't ask a barber whether you need a haircut. But if, as a chief executive, you want to earn more, then it makes sense to hire a compensation consultant. That is the conclusion of a new academic paper from the Judge Business School at Cambridge University. Previous studies had not shown a significant effect.
The  new study was made possible by a SEC rule change in 2009 that required firms that purchased services from compensation consultants to disclose the fees paid. If the firm was hired solely for compensation purposes, the disclosure rule did not apply. (The fear was a potential conflict of interest; consultants would please the managers by recommending higher pay in the hope of keeping lucrative fees earned by providing other services.)
The academics compared companies that retained multi-service providers after 2009 to those who switched to hiring specialist compensation consultants after that date. They reasoned that client firms that switched to the newly spun-off “independent” specialist consultants (where consultant compensation does not have to be disclosed) are the ones that previously gave the multi-service consultants the additional business in order to influence the executive compensation advice upwards. In contrast, firms that stayed with their existing multiservice consultants (and disclosed the amount of consultant compensation) are likely to have hired the multi-service consultants for reasons that are in line with shareholder interest. Therefore, by comparing CEO pay levels at the switchers against the stayers, we are able to examine the influence of conflicted consultants on executive pay
Secondly, they compared consultants hired by the management directly after the 2009 rule change, with those retained by the board. The academics argue that

management-retained consultants are more likely to be biased towards their clients, and therefore firms where managers are able to better fight for their own interests are likely to pay the CEOs more.

Third, they look at consultant turnover to see if executives reward consultants by retaining their services if they have recommended higher pay. The academics investigate whether

an increase in client executive pay is associated with the likelihood of the consultant being turned over in the following year. If an increase in pay is associated with a subsequent lower probability of being replaced by a competitor, then consultants indeed have an incentive, on average, to recommend higher pay.

What were the results? You will be shocked, shocked to learn that your worst suspicions are confirmed. Yes, firms that hire pay consultants pay their executives 7.5% more than those who don't. Yes, companies that hung on to their multi-service consultants paid their executives 10% less than those that switched to specialist consultants. Executives who work at firms where the board hired the consultants earned 13% less than when the consultants were hired by the management themselves. When executives get a big pay rise, their companies are less likely to replace their consultants in the following year.
The authors conclude that

our study finds strong empirical evidence for the hiring of compensation consultants as a justification device for higher executive pay.

So, be very suspicious of arguments that higher executive pay is the result of the "war for talent", the unique importance of the CEO in a globalised world, or whatever. If such arguments were true, it should make no difference whether consultants are hired or not. This smacks more of the famous lickspittle courtier of Louis XIV, the Sun King, who, when asked the time, replied "It is whatever time your majesty pleases". "Whatever pay your majesty pleases" is the modern equivalent.