Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts

We examine the explicit use of relative performance evaluation (RPE) in executive compensation contracts and the selection of RPE peers. Using S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules, we demonstrate that incorporating details of RPE contracts (such as peer group composition) in the traditional implicit test significantly improves the power to detect RPE use. Our findings suggest that firms consider both costs and benefits of RPE as a form of incentive mechanism when deciding to use RPE. Moreover, the evidence supports both efficient contracting and rent extraction behavior in the RPE peer selection process. Consistent with efficient contracting, RPE firms, especially those with superior performance, tend to select peers that exhibit higher ability to remove common risk and improve fairness in competition. We also find rent extraction behavior in forming RPE peer groups, as evidenced by a negative relation between peer performance and the likelihood of being selected as a peer, especially among underperforming RPE firms.