If you hire them, pay will come

WARREN BUFFETT once noted that if you want independent advice, don’t ask a barber whether you need a haircut. But if, as a chief executive, you want to earn more, then it makes sense to hire a compensation consultant. Or so concludes a new study* from the Judge Business School at Cambridge University.

Though its findings hardly seem a shock, previous studies that tried to link bosses’ pay and the use of consultants had found no significant effect. However, this new research was made possible by a rule brought in by America’s Securities and Exchange Commission (SEC) in 2009. It says that when a company hires a consultant for advice on both compensation and other matters, it must disclose the fees paid in each case. When consultants are hired solely to give advice on compensation, the fee need not be disclosed.

The reason for this asymmetric rule was that the SEC feared some bosses were in effect bribing consultants to recommend them for pay rises by bunging them lots of other, more lucrative work. Making the fee structure more transparent would discourage the practice, the regulator hoped.

The academics used three tests. First, they compared companies that kept their “multi-service” advisers after 2009 with those that switched to using specialist compensation consultants to advise them on executive pay. Those that switched were found to be paying their CEOs almost 10% more than similar firms that had hung on to their multi-service consultants. One obvious explanation is that the switchers were those firms that had been offering extra business to their consultants mainly to influence their advice on executive pay—for as long as they could do so without revealing it—and that this had worked.

The second test was to look at who chose any specialist pay advisers hired after the rule change. In firms in which the consultants were only chosen by the board, the CEO was paid about 13% less than at similar firms whose CEO also hired a second set of pay advisers.

The third test was consultant turnover. The academics reasoned that “If an increase in pay is associated with a subsequent lower probability of being replaced by a competitor, then consultants indeed have an incentive, on average, to recommend higher pay.” The trend was again clear. When CEOs get big pay rises their companies are less likely to replace their consultants in the following year.

All told, the academics found that firms that hire compensation consultants paid their CEOs 7.5% more than those that did not. They concluded that “our study finds strong empirical evidence for the hiring of compensation consultants as a justification device for higher executive pay.”

These findings make it a little harder to argue that higher CEO pay is linked to shareholder returns or to greater talent; if that were the case, one would not expect such a clear correlation between pay and the use of consultants. The trend smacks more of the lickspittle courtier of Louis XIV, who, when asked the time, replied, “It is whatever time your majesty pleases.” The modern equivalent is, it seems, “Whatever pay your majesty pleases.”

_{*"Do Compensation Consultants Enable Higher CEO Pay? New Evidence from Recent Disclosure Rule Changes", by Jenny Chu, Jonathan Faasse and Raghavendra Rau}