How Government Regulation Put The Boosters On Sky Rocketing CEO Pay

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Guy Bentley Research Associate, Reason Foundation
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One government rule to make top CEO pay transparent spiraled into a race to the top with bosses landing even bigger paychecks.

Many of America’s largest companies have used the practice of peer benchmarking to set executive pay for years. Benchmarking is when the company awards CEO compensation at similar levels to rival businesses in their industry.

Benchmarking is used as a rough and ready way to judge talent in the industry and how to appropriately compensate high-level individuals. In 2006, in an attempt to improve transparency, the Securities and Exchange Commission issued a new disclosure requirement.

Companies would now have to tell investors and the public who they benchmark against. The rule, seen as relatively benign at the time rapidly produced some unintended consequences.

Professor Michael Faulkender, who published a paper on the subject found that disclosing compensation peer groups to investors helped explain “variations in chief executive officer (CEO) compensation beyond that of other benchmarks such as the industry-size peers.” The paper examined more than 600 companies and looked at the peer CEOs that influenced CEO compensation decisions.

Speaking to The Daily Caller News Foundation, Faulkender said companies were “more likely to select peers with higher compensation” leading to a situation where companies were hiking CEO pay. The first year of disclosures did not have a significant impact as it was the first time investors saw who they were benchmarking against.

But after three years, Faulkender, along with his colleague professor Jun Yang found that “firms appear to select highly paid peers to justify their CEO compensation and this effect is stronger in firms where the compensation peer group is smaller, where the CEO is the chairman of the board of directors, where the CEO has longer tenure, and where directors are busier serving on multiple boards.”

CEOs on lower pay than their peers were able to demand pay increases to keep up with their competitors. “We always have to be mindful of unintended consequences,” said Faulkender. While the recent trend toward votes on executive pay may have a tempering effect, Faulkender added that “regulators need to be mindful to reverse policy decisions.”

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Guy Bentley