Like all other aspects of executive compensation management, the competitive benchmarking process is coming under harsh scrutiny. This poses particular challenges for the selection of an organization's competitive peer group, the group of similar businesses that are selected and used for the purpose of compensation and performance comparisons.
Jim Heim, managing director of Pearl Meyer & Partners, in an article "Peer Group Pitfalls" published in the October issue of WorldatWork's workspan magazine, hones in on the five most common obstacles we encounter in this process and provides some advice for overcoming them.
From the article, in summary:
Obstacle No. 1: Our Competitors Are Generally Larger (or Smaller). Ideally a peer group should include somewhat larger and smaller companies, such that your firm's size approximates the group median. When this doesn't hold true, consider a couple of alternatives. First, use regression analysis techniques to determine "predicted" pay levels for a company your size. Second, select a reference point (e.g., the 25th percentile) that is either above or below the group median, but reflective of your company's size and place in the group.
Obstacle No. 2: We have Outperformed (or Underperformed) Our Competitors. Year-to-year performance can vary significantly, and using annual performance as a key to peer group selection can result in substantial churn in the group roster from one year to the next. For a more consistent set of comparisons, use longer-term (e.g., a three-year aggregate) financial performance measure(s), preferably those that are most meaningful to your investors and analysts.
Obstacle No. 3: We Generally Recruit Executive Talent From Larger Firms. "Aspirational" peer groups (groups that include larger, more complex, higher-performing firms which the company wishes to target for recruitment) have been rightly criticized when used as the sole reference point for benchmarking executive pay. A more acceptable approach might be to develop and utilize two separate peer groups; one of aspirational peers and the other of size-relevant companies. If strong financial performance is sustained over time, the aspirational peer group will become increasingly size relevant.
Obstacle No. 4: We Have Few Clear, Direct Competitors for Our Product or Service Offerings. It may be that direct competitors are foreign-based, privately held or subsidiaries of larger companies, or it may just be that your company operates in a pretty specialized niche. In such situations, the best approach may be using firms from "like" industries - in the way that brewers, distillers and winemakers may be considered like industries. Be mindful of any particular differences in financial performance, choice of pay vehicles, etc. from one like industry to another.
Obstacle No. 5: Our Industry is Consolidating and Several of Our Competitors Were Acquired. Industry consolidation makes it difficult to maintain a consistent year-to-year frame of reference. Companies should establish a thorough, rules-based process of revisiting their selection every year to determine whether new firms should be added and any current firms removed. This will ensure that the peer group used each year is valid for external benchmarking, even if there has been turnover in the group roster.
With all that is happening in our world and markets these days, this challenge will only get tougher.