The Role and Effect of Compensation Consultants on CEO Pay

Brian Cadman

The Wharton School Northwestern University

b-cadman@kellogg.northwestern.edu

Mary Ellen Carter The Wharton School

carterme@wharton.upenn.edu

Stephen Hillegeist INSEAD

Stephen.Hillegeist@INSEAD.edu

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.

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,

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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 75th percentile of the salary from their designated peer group.

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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.

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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-for-

performance 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.

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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

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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 compensation-

related 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

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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.

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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.”

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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.

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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.

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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 pay-

performance 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.

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compensation schemes with easily attainable targets, resulting in weaker pay-

performance 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

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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 one-

third 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 2006.

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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 2006. In addition, these firms have average book-to-market of

0.44. 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 2006. 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.

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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:

COMPENSATIONj = α0 + α1ASSETSj + α2BMj + α3ROAj + β1TOP_CONSULTj + β2OTHER_CONSULTj + Σ αiINDj + εj (1)

where:

COMPENSATIONj = 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;

ASSETSj = Log of total assets (Compustat Data Item 6) of firm j in 2006; BMj = 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;

ROAj = Return on assets (Compustat Data Item 172 / Compustat Data Item 6) of firm j in 2006;

INDj = 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.,

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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 β1

and β2 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 β2 > β1. 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 β2 < β1 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 compensation11:

COMPENSATIONj = α0 + α1ASSETSj + α2 BMj + α3ROAj + β1TOP_CONSULTj + β2OTHER_CONSULTj + β3TOP_CONSULTj*ROAj + β4OTHER_CONSULTj *ROAj (2) + ΣαiINDj + εj

Where the variables are as defined in Eq. (1).

Positive coefficients on the interaction of consultant with ROA (β3 and β4) 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.

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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

(β1 > 0 and β2>0) after controlling for performance. In addition, investigating the

difference between β3 and β4 provides evidence on the difference in the pay-for-

performance 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:

WORDj = α0 + α1NO_EXECj + α2PENSIONj + β1TOP_CONSULTj + β2OTHER_CONSULTj + ΣαiINDj + εj (3)

where all other variables are defined as before and:

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WORDj = The number of words in the CD&A for firm j in 2006; NO_EXECj = The number of executives included in the Summary Compensation

table of the proxy statement for firm j in 2006; PENSIONj = 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.

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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

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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 β1 = β2. 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

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 β1 + β1 <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

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 β3+β4 =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

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

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 2006. 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

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

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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Brancato, C. 2002. Is the compensation committee of the board up to its new role?

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Core, J., R. Holthausen, and D. Larcker. 1999. Corporate governance, chief executive

officer compensation, and firm performance. Journal of Financial Economics 51: 371-406.

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Gillian, S. 2001. Option-based compensation: panacea or Pandora’s box? Journal of Applied Corporate Finance, 14:115-128.

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10. Morgenson, G. 2006b. Peer Pressure: Inflating Executive Pay, New York Times,

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29

Table 1 Descriptive statistics of 292 firms randomly selected from ExecuComp

Panel A: Summary Statistics of Firm Characteristics in 2006

Ln Assets Book to Market ROA Word Count of

CD&A Mean 8.365 0.440 5.255 11880

10th Percentile 6.408 0.184 0.182 6082

50th Percentile 8.305 0.413 4.509 11302

90th Percentile 10.592 0.752 12.426 18304

Std. Deviation 1.702 0.217 4.608 4961

Ln Assets = Log of total assets (Compustat Data Item 6) of the firm in 2006, Book to Market = 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 the firm in 2006, ROA = Return on assets (Compustat Data Item 172 / Compustat Data Item 6) of the firm in 2006, Word Count of CD&A is the number of words in the compensation discussion and analysis for the firm in 2006. Panel B: Industry Distribution

Industry Number Percent Mining and Construction 6 2.05 Food 4 1.37 Textiles, Printing 20 6.85 Chemicals 7 2.4 Pharmaceuticals 11 3.77 Extractive Industries 12 4.11 Durable Manufacturers 61 20.89 Computers 11 3.77 Transportation 18 6.16 Utilities 30 10.27 Retail 19 6.51 Financial Institutions 54 18.49 Insurance and Real Estate 9 3.08 Services 28 9.59 Other 2 0.68 Total 292 100 Industries are based on Barth et al (1998) classifications

30

31

Table 1 (continued) Descriptive statistics of 292 firms randomly selected from ExecuComp

Panel C: Distribution of Consultants by Firm

Firm Frequency Percentage CumulativeAnonymous 9 3.08 3.08 Aon Consulting 3 1.03 4.11 Buck Consulting 6 2.05 6.16 Clark Consulting 1 0.34 6.51 Compass Consulting & Benefits, Inc 1 0.34 6.85 Compensia 3 1.03 7.88 Deloitte Consulting 4 1.37 9.25 Delves Group 1 0.34 9.59 Denver Management Advisors 1 0.34 9.93 ECG Advisors 2 0.68 10.62 Ernst & Young 3 1.03 11.64 FPL Associates 1 0.34 11.99 Frederic W. Cook* 29 9.93 21.92 Gough Management Company 1 0.34 22.26 Hay Group 5 1.71 23.97 Hewitt Associates* 31 10.62 34.59 Johnson Associates 1 0.34 34.93 KPMG 1 0.34 35.27 Longnecker and Associates 2 0.68 35.96 Lyons, Benenson & Company Inc 1 0.34 36.3 Mercer Human Resources Consulting* 39 13.36 49.66 Ovia Insurance Services National Compen 1 0.34 50 PayCraft Consulting 1 0.34 50.34 Pearl Meyers & Partners 14 4.79 55.14 PricewaterhouseCoopers 3 1.03 56.16 Radford 1 0.34 56.51 Schuster-Zingheim and Associates, Inc 1 0.34 56.85 Semler Brossy Consulting Group 5 1.71 58.56 Steven Hall & Partners 1 0.34 58.9 Strategic Apex Group 2 0.68 59.59 Top Five Data Services 1 0.34 59.93 Towers Perrin* 47 16.1 76.03 Watson Wyatt* 25 8.56 84.59 No consultant 45 15.41 100 Total 292 100

* Indicates the consultant is identified as a "Top consultant"

Table 2 Summary Statistics of Executive Compensation

(1) (2) (3)

No

consultant Other

Consultant

test of difference

(2)-(1) Top 5

Consultant

test of difference

(3)-(2) N=45 N=76 N=171 Salary mean 559.15 807.24 *** 876.6 ** (median) (480.00) (745.91) *** (864.20) * Bonus mean 1255.44 1512.45 2012.28 * (median) (400.00) (1062.50) *** (1116.42) Total Cash mean 1814.6 2319.69 2888.88 * (median) (855.00) (1778.63) *** (1922.73) Total Direct mean 3857.19 6926.18 *** 8222.12 (median) (1581.39) (4406.69) *** (5660.46) Stock mean 876.72 1958.51 *** 2047.48 (median) (0.06) (643.90) *** (968.00) Options mean 825.02 1184.22 1651.04 *** (median) (0.00) (28.55) (778.00) *** *, **, *** indicates a significant difference in the mean (t-stat) and median (Wilcoxian rank-sum test) at the 10, 5, and 1 percent confidence interval respectively. Salary is the annual salary in thousands, Bonus is the annual bonus in thousands, Total Cash is the sum of salary and bonus, Total Direct is the sum of cash and the fair value of the equity grants throughout the fiscal year, Stock is the fair value of the stock granted to the CEO in the fiscal year, Options is the fair value reported by the firm of the options granted in the fiscal year. Top 5 Consultant represent clients of the consultants that represent the 5 largest market shares in our sample. Other Consultant represents clients of the other consultants in our sample.

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Table 3 Evidence on the influence of Compensation Consultants on the Level and Sensitivity of Compensation

Salary Bonus Total Cash Comp Total Direct Comp Coef. (1) (2) (3) (4) (5) (6) (7) (8) Ln Assets α1 156.379*** 158.063*** 785.639*** 806.005*** 942.018*** 964.069*** 3,122.685*** 3,171.975*** (13.1) (13.0) (7.28) (7.23) (8.36) (8.30) (12.7) (12.6) Book-to-Market α2 0.745 -2.307 -573.081 -616.107 -572.337 -618.414 -4,624.290*** -4,285.372** (0.0096) (-0.030) (-1.05) (-1.13) (-0.99) (-1.07) (-2.69) (-2.58) ROA α3 2.419 -3.343 93.788*** 10.028 96.207*** 6.685 157.539 -168.634 (0.68) (-0.48) (2.77) (0.17) (2.74) (0.10) (1.40) (-1.08) Residual Equity Incentives α4 4.331 62.629 (0.0093) (0.13) Other Consultant β1 109.637** 106.619 -128.817 -447.306 -19.180 -340.686 841.440 -81.747 (2.19) (1.24) (-0.35) (-1.11) (-0.049) (-0.76) (0.86) (-0.054) Top 5 Consultant β2 100.371** 34.677 -171.784 -979.169* -71.414 -944.492* 490.384 -2,733.069 (2.21) (0.45) (-0.40) (-1.84) (-0.16) (-1.65) (0.47) (-1.59) Other Consultant * ROA β3 -0.975 44.341 43.366 118.935 (-0.10) (0.61) (0.56) (0.67) Top 5 Consultant * ROA β4 10.951 134.428 145.379 519.619* (1.41) (1.29) (1.35) (1.88) Constant -495.535*** -465.367*** -3,822.109*** -3,361.733*** -4,317.644*** -3,827.100*** -11,095.023** -9,950.905** (-4.01) (-3.72) (-3.01) (-2.64) (-3.26) (-2.87) (-2.24) (-2.14) N 292 292 292 292 292 292 234 234 Adjusted R-square 0.542 0.544 0.221 0.224 0.266 0.270 0.443 0.458 Hypothesis tests (F-Tests) test of β1 + β2 = 0 5.68*** 0.89 0.16 3.16** 0.01 2.08 0.63 0.90 test of β1 = β2 0.06 1.21 0.02 1.14 0.01 1.39 0.48 4.48*** test of β3 + β4 = 0 - 0.41 - 1.47 - 1.48 - 2.58** test of β3 = β4 - 2.40* - 0.76 - 0.95 - 2.79** Huber-White robust standard errors are provided (in parentheses). *, **, *** indicate significance t-stats (F-stats) at the 10, 5, and 1 percent confidence intervals. The model includes industry indicator variables based on Barth et al., (1998) classifications (not reported). Variables are as defined in Tables 1 and 2.

33

Table 4 Evidence on the influence of Compensation Consultants on the

Level and Sensitivity of Compensation Splitting ROA

Salary Bonus Total Cash Comp Total Direct Comp Coef. (1) (2) (3) (4) Ln Assets α1 161.057*** 835.680*** 996.737*** 3,259.681*** (13.4) (6.95) (7.99) (11.9) Book-to-Market α2 13.232 -459.643 -446.412 -3,299.391* (0.17) (-0.84) (-0.78) (-1.74) ROA_NEG α3 -49.494 -504.309** -553.803* -1,781.345* (-1.10) (-1.98) (-1.95) (-1.79) ROA_POS α4 4.620 96.567 101.187 124.989 (0.37) (1.05) (1.02) (0.52) Residual Equity Incentives α5 165.708 (0.35) Other Consultant β1 138.094 138.558 276.652 2,189.131 (1.06) (0.23) (0.41) (0.96) Top 5 Consultant β2 88.383 -372.840 -284.458 -1,119.548 (0.73) (-0.51) (-0.36) (-0.46) Other Consultant * ROA_NEG β3 4.234 415.410 419.645 1,810.156* (0.062) (1.22) (1.19) (1.66) Other Consultant * ROA_POS β4 -3.643 -18.065 -21.708 -123.898 (-0.26) (-0.17) (-0.19) (-0.48) Top5 Consultant * ROA_NEG β5 46.597 539.985* 586.582* 1,214.109 (0.91) (1.75) (1.73) (1.07) Top 5 Consultant * ROA_POS β6 5.076 67.591 72.667 364.987 (0.40) (0.49) (0.51) (1.04) Constant -568.438*** -4,470.047*** -5,038.484*** -13,611.285** (-3.25) (-2.90) (-3.11) (-2.42) N 292 292 292 234 Adjusted R-square 0.544 0.220 0.267 0.459 Hypothesis tests (F-tests) test of β1 + β2 = 0 0.89 0.04 0.00 0.06 test of β1 = β2 0.43 0.50 0.57 3.70*** test of β4 = β6 0.34 0.41 0.49 2.61* test of β3 = β5 0.45 0.13 0.22 0.36 test of β4 + β6 = 0 0.00 0.06 0.05 0.20 test of β3 + β5 = 0 0.24 3.04** 2.86** 2.32** Huber-White robust standard errors are provided (in parentheses). *, **, *** indicate significance t-stats (F-stats) at the 10, 5, and 1 percent confidence intervals. The model includes industry indicator variables based on Barth et al., (1998) classifications (not reported). Variables are as defined in Tables 1 and 2.

34

Table 5 Word Count of the CD&A

Coefficient Other Consultant β1 2,825.163*** (3.98) Top 5 Consultant β2 3,853.904*** (5.93) Number of executives listed β3 961.198*** (2.93) CEO Pension β4 3,280.230*** (5.94) Constant 2,722.753 (0.96) N 292 Adjusted R-square 0.249 Hypothesis tests (F-tests) test of β1 + β2 = 0 31.02*** test of β1 = β2 2.55* Huber-White robust standard errors are provided (in parentheses). *, **, *** indicate significance t-stats (F-stats) at the 10, 5, and 1 percent confidence intervals. CEO pension is an indicator variable equal to 1 if the CEO earns a pension. Number of executive listed is the number of named executives identified in the compensation table of the annual proxy statement. The model includes industry indicator variables based on Barth et al., (1998) classifications (not reported). Variables are as defined in Tables 1 and 2.

35