Do Compensation Consultants Have Distinct Styles?

Chen Cai
Georgia State University – Department of Finance

Omesh Kini
Georgia State University

Ryan Williams
University of Arizona – Department of Finance

April 1, 2016


We hand collect compensation consultant data from proxy statements (DEF 14A) for ExecuComp firms over the period 2006-2010. We investigate whether compensation consultants exhibit distinct styles in the determination of pay level and compensation structure of CEOs after accounting for their economic determinants. Our tests, which include the use of placebo samples that involve the scrambling of consultants as benchmarks, yield little evidence of idiosyncratic compensation consultant style. We do find style-like effects for a subsample of hiring firms with weak governance mechanisms which, in turn, are largely driven by firms that hire less reputable compensation consulting firms. In this subsample, we further find that client firms’ values are significantly lower if their consultants recommend a higher salary or higher salary as a percentage of total compensation. We also find style-like effects in a subsample comprised of consultants who face conflicts of interest resulting from having other ongoing business relations with the client firms. In this subsample, we find that consultants who recommend higher equity-based compensation are subsequently associated with lower client firm values and greater accrual management. We conclude that the choice of consulting firm does not matter for client firms with strong governance mechanisms (other than for certification reasons) because any hired consultant will provide advice based on the client firm’s economic characteristics and environment. However, we do observe style-like effects and some resultant perverse outcomes, either when (i) there is greater potential for client firms’ managers to take actions in their self-interest combined with weaker incentives for consultants to provide objective advice or (ii) consultants face conflicts of interest.

Do Compensation Consultants Have Distinct Styles? – Introduction

We investigate whether the choice of a specific compensation consultant affects the compensation level and structure of top managers. This question is important because the compensation schemes of top managers will influence their behavior and, consequently, impact firm economic outcomes.1 Compensation consultants are typically hired by the board of directors’ compensation committee to help craft compensation policies for the top managers of the corporation. Compensation consulting firms may also provide other highly lucrative services to the client firm in the form of employee benefits management, actuarial services, human resource management, etc. The extant literature on compensation consultants has largely focused on the impact of hiring compensation consultants on the pay level and structure, whether compensation consultants are influenced by cross-selling incentives and desire to secure repeat business in setting the pay level and structure, and whether higher pay level is attributable to the client firm’s governance environment or due to the use of a compensation consultant.2 Compensation consultants can, however, imprint their own distinct styles in fashioning compensation policies for a firm. Our unique contribution to this literature is that we examine whether individual compensation consultants influence compensation policies after controlling for the known economic determinants of these policies.

Compensation consultants strive to signal unique styles in a positive manner via their own advertising. For example, Towers Watson claims to “bring a unique portfolio of resources” to the table, with an emphasis on aligning board actions with shareholders (e.g., avoiding “say on pay” disputes). Their advertising also notes that:

We found that each company approaches the design and governance of executive compensation programs in its own way, taking into account a number of variables, including the company’s history and culture, its specific business and talent strategies, and the shareholder relations environment.3

Conversely, the media has reported that consulting advice varies little. For example, Towers Perrin was accused in 1997 of giving nearly identical reports on workplace diversity to multiple consulting clients across different industries.4 Towers Perrin’s response was that all of the clients reported in the article faced similar economic forces and, therefore, received similar advice.5 Thus, the anecdotal evidence on consultant style is mixed.

Compensation Consultants

In recent times, compensation consultants have been in the direct line of fire from academics, board members, and policy makers. For example, Bebchuk and Fried (2014) take the view that managers will influence the employment of consultants who are likely to recommend higher pay and use their advice to justify excessive compensation. They further argue that compensation consultants, driven by their cross-selling incentives and/or desire to obtain repeat business, design compensation plans that provide excessive pay to managers. Thus, they suggest that compensation consultants worsen, rather than alleviate, agency problems within firms. Board members also claim that compensation consultants are to blame for spiraling CEO pay (Workforce, February 7, 2008).6 Finally, the former SEC Commissioner Roel C. Campos in a speech stated, “Another significant driver of excessive CEO compensation is the use of compensation consultants.” He goes on to add, “It is extremely difficult to avoid using high comparables, and consultants can pretty much find high comparable income data to support paying a high amount to the CEO. This is the case even if the consultant reports directly to the board.”

Thus, it is an open question whether individual compensation consultants: (i) have distinct styles and managers/boards hire consultants with a specific style, (ii) do not have distinct styles, but instead give compensation advice based purely on economic characteristics, and (iii) respond in a distinct manner to the incentives that arise from the governance environment of the client firm and their own self-interest. We investigate these issues in this paper. In the process, we attempt to shed light on whether compensation consultants facilitate compensation arrangements that reflect a competitive equilibrium in the level of pay and an efficient equilibrium in the incentives provided by optimal contracts (the “efficient” view) or that compensation contracts are written by captive boards and pliant compensation consultants to enhance the welfare of powerful CEOs (the “agency” view).

Compensation Consultants

The roadmap for our paper is as follows. The primary question that we empirically investigate in this paper is whether compensation consultants have idiosyncratic styles in the setting of CEO pay level and structure of compensation. In the event we do not find evidence consistent with consultant style, we will investigate whether this is attributable to consultants giving compensation advice based solely on the economic circumstance of the firm (the efficient view) or the advice they provide is influenced by the incentives that they face (the agency view). On the other hand, if we find evidence consistent with consultant style, we will investigate whether consultant style more strongly manifests itself when the consultant faces incentives to provide compromised advice (the agency view) or whether better governed client firms optimally select consultants with distinct styles (the efficient view).

Compensation Consultants

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