THOUSAND OAKS, Calif. — As the board of Amgen convened at the company’s headquarters in March, chief executive Kevin W. Sharer seemed an unlikely candidate for a raise.
Shareholders at the company, one of the nation’s largest biotech firms, had lost 3 percent on their investment in 2010 and 7 percent over the past five years. The company had been forced to close or shrink plants, trimming the workforce from 20,100 to 17,400. And Sharer, a 63-year-old former Navy engineer, was already earning lots of money — about $15 million in the previous year, plus such perks as two corporate jets.
The board decided to give Sharer more. It boosted his compensation to $21 million annually, a 37 percent increase, according to the company reports.
The company board agreed to pay Sharer more than most chief executives in the industry — with a compensation “value closer to the 75th percentile of the peer group,” according to a 2011 regulatory filing.
This is how it’s done in corporate America. At Amgen and at the vast majority of large U.S. companies, boards aim to pay their executives at levels equal to or above the median for executives at similar companies.
The idea behind setting executive pay this way, known as “peer benchmarking,” is to keep talented bosses from leaving.
But the practice has long been controversial because, as critics have pointed out, if every company tries to keep up with or exceed the median pay for executives, executive compensation will spiral upward, regardless of performance. Few if any corporate boards consider their executive teams to be below average, so the result has become known as the “Lake Wobegon” effect.
It wasn’t until recently, however, that its pervasiveness and impact on executive pay became clear. Companies have long hid the way they set executive pay, but in late 2006, the Securities and Exchange Commission began compelling companies to disclose the specifics of how they use peer groups to determine executive pay.
Since then, researchers have found that about 90 percent of major U.S. companies expressly set their executive pay targets at or above the median of their peer group. This creates just the kinds of circumstances that drive pay upward.
Moreover, the jump in pay because of peer benchmarking is significant. A chief executive’s pay is more influenced by what his or her “peers” earn than by the company’s recent performance for shareholders, according to two independent research efforts based on the new disclosures. One was by Michael Faulkender at the University of Maryland and Jun Yang of Indiana University, and another was led by John Bizjak at Texas Christian University.
“Peer benchmarking has a significant influence on CEO pay,” Bizjak said. “Basically, you can’t have every CEO paid above average without pay ratcheting upward over time.”
‘All the other kids have one’
The gap between what workers and top executives make helps explain why income inequality in the United States is reaching levels unseen since the Great Depression.
Since the 1970s, median pay for executives at the nation’s largest companies has more than quadrupled, even after adjusting for inflation, according to researchers. Over the same period, pay for a typical non-supervisory worker has dropped more than 10 percent, according to Bureau of Labor statistics.
Critical to executive pay levels is peer benchmarking.
Even before the extent of the practice was known, it drew criticism from prominent business figures. After the Enron scandals, a blue-ribbon committee led by Peter G. Peterson, then chairman of the Federal Reserve Bank of New York, and John Snow, former chairman of the Business Roundtable, called for setting executive pay “unconstrained by median compensation statistics.” Legendary investor Warren Buffett, in one of his famously plain-spoken letters to investors, likewise derided the method.
“Outlandish ‘goodies’ are showered upon CEOs simply because of a corporate version of the argument we all used when children: ‘But, Mom, all the other kids have one,’” he wrote.
Similarly, former Federal Reserve chairman Paul Volcker called it the “Lake Wobegon syndrome” in congressional testimony in 2008, referring to Garrison Keillor’s fictional town where “all the children are above average.”
The practice has persisted because corporate board members, many of whom have personal or business relationships with the chief executive, have been unwilling to abandon the practice.
At Amgen, for example, four of the six members of the board compensation committee had personal or business connections to Sharer before joining the board. In fact, he nominated at least two of the six to the board, according to a company source and reports.