How Peer Pressure Imperils Your Profits

Most of us associate "peer pressure" with the perils of high school -- if you want to be one of the cool kids, you'd better act like them, even if their behavior isn't a great idea. However, peer pressure is alive and well in corporate America, and it can plunder your long-term profits.

A corporate chief executive officer who makes more money than he or she is worth destroys shareholder value, and there are plenty of CEOs who simply don't seem worth their lucrative paychecks.

One of the ways CEO pay skyrockets into the stratosphere is through a practice called "peer benchmarking." Investors should demand corporate America grow up and stop using this kind of peer pressure -- it can yield negative financial outcomes for everyone except the chief executives in question.

Define "above average"
This week, The Washington Post highlighted how using peer benchmarking to devise CEO pay schemes can be very problematic for investors.

Basically, analyses of "reasonable" pay packages tend to include an assessment of median CEO pay from a pool of industry peers. Corporate boards obviously aren't going to say that the chief executives they have chosen and support are "below average," so many CEOs end up receiving more than the average pay in their industries.

The Post offered Amgen (Nasdaq: AMGN  ) as a prime example. Last spring, CEO Kevin Sharer's pay level increased 37% to $21 million. Had he been doing a bang-up job, we wouldn't have much right to say a word. However, in 2010, investors saw 3% of their Amgen investment disappear, and 7% of its value has vaporized over a five-year period. In addition, Amgen has let go 13% of its workers.

Still, Amgen's board has chosen to pay Sharer more than most chief executives in the industry; his pay is in the 75th percentile. Does this sound like an above-average CEO to you?

Define "peer"
Some weird peer groups exist, too. Media companies are an interesting place to look. These companies tend to have very highly paid chief executives, and some very interesting peers for benchmarking purposes.

Let's run through Time Warner (NYSE: TWX  ) as an example. It's not really what one would call a very high-growth company. The failed marriage with AOL (NYSE: AOL  ) also sullies its track record. Maybe investors who bought Time Warner shares in the beginning of 2010 are content with the 7% annualized returns they've seen in that time, but over the years the stock has consistently lagged the S&P 500 index. Its stock performance over the past five years has also greatly lagged that of Google (Nasdaq: GOOG  ) , a high-growth stock that's also an operational powerhouse.

Still, CEO Jeff Bewkes landed on compensation research firm Equilar's list of top 10 highest-paid CEOs for 2010. Bewkes' total payday clocked in at $26.1 million.

Time Warner uses one peer group in the entertainment and media industry for benchmarking purposes, and that peer group is a very well-paid bunch in its own right. It includes other CEOs that made Equilar's Top 10 list -- namely, Viacom (NYSE: VIA  ) (2010 CEO pay: $84.5 million) and CBS (NYSE: CBS  ) (2010 CEO pay: $56.9 million).

In addition, Time Warner takes a larger "industry peer group" into consideration that's comprised of "multi-national and multi-divisional companies with consumer-oriented branded businesses that generally have revenues similar in size to Time Warner, and is intended to reflect a broader range of major companies with which Time Warner may compete for executives."

The 23 other "peers" in question include wildly disparate companies like Hewlett-Packard (NYSE: HPQ  ) (known for CEO compensation controversies of its own), Johnson & Johnson (NYSE: JNJ  ) (where CEO William Weldon drew attention for high paychecks despite J&J's product recalls and widespread worker layoffs), and General Electric. Of these, Bewkes' pay comes in at the 75th percentile. (Granted, his pay actually lags the closer entertainment and media industry peers.)

Define shenanigans
Analyzing peer groups to help devise market-based CEO pay schemes makes sense on paper, but the reality is much different. Take a look at the compensation disclosures in your stocks' proxy statements every year, and check out the peer groups.

Always ask if your companies' CEOs are really worth their massive paychecks, look for anomalies and weirdness, and remember to hold your companies' boards (particularly their compensation committees) accountable for any sign of sneaky shenanigans.

Peer groups' impact on CEO pay can be a confusing journey through proxy statements, but the fact is this practice almost guarantees that CEOs make bank regardless of performance, instead of focusing on shareholders making long-term profits.

It's too bad peer pressure didn't stay in high school, but our awareness of how the practice can hurt our own investment returns might result in more of us exerting a little peer pressure of our own.

Check back at Fool.com every Wednesday and Friday for Alyce Lomax's columns on environmental, social, and governance issues.

Alyce Lomax does not own shares of any of the companies mentioned. The Motley Fool owns shares of Google and Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Google and Johnson & Johnson, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On October 08, 2011, at 9:25 AM, XMFDRadovsky wrote:

    Hi Alyce,

    The Washington Post reported that this above-average peer compensation was thought of as the "Lake Woebegone Effect", for Garrison Keillor's statistically impossible description of the town as a place where "...all the children are above average."

    That's a helluva bell curve.

    Dan

  • Report this Comment On October 10, 2011, at 8:39 AM, TMFLomax wrote:

    Hi Dan,

    Yeah, I've definitely heard this described as "the Lake Woebegone Effect" even before the Post article -- The Corporate Library's Nell Minow has made that same analogy in the past. It's a disservice to shareholders (and yes, not a reflection of reality not to mention statistically impossible, ha!).

    Best,

    Alyce

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