How is Comparability Data Used in Setting Exec Comp?Stephen D. Kirkland CPA, CMC, CFC, CFF
November 18, 2013 — 2,128 views
We often need to determine reasonable compensation amounts for executives, attorneys, charity managers, trustees, or retirement plan service providers. This is an important process and should not be taken lightly.
At first blush, it is tempting to assume that the market establishes reasonableness. Hence, we use benchmarking, which involves comparing one company to another. Or, more specifically, it involves comparing one person’s pay level to amounts paid by other companies, which is known as comparability data.
Comparability data is market or industry data that can be used for making comparisons (i.e. amounts that similar employers have paid to similar employees).
In its simplest form, this just means looking to see what other companies in the same industry paid to their executives. For example, “If similar companies paid their CEOs $x, then that amount must be reasonable for our CEO.” This is a way of letting other companies decide what is reasonable. Here are some words of caution, however.
It is always interesting to see what others have been paid, but we should not be too quick to draw conclusions. First, let’s ask whether all incumbents provided the same value. Carefully consider these questions: Do all doctors provide the same service? Do all attorneys provide their clients the same value? Do all consultants perform the same work? And do all executives accomplish the same results?
The point is – be careful when benchmarking. Do not be too simplistic in the approach and don’t make careless assumptions.
Therefore, it may be best if you can get true comparables. This means similar-sized companies in the same industry and the same geographic area. Perhaps the other companies had a similar growth rate and comparable profitability? Perhaps the individuals being benchmarked had similar duties and performed at the same level? Finding exact matches is usually not possible. Therefore, we use surveys or compilations of amounts paid by companies in the same or similar industries.
Comparability data may also include compensation amounts paid to the same individual in an earlier year. The theory is: if she was worth $x in earlier years at a previous employer, then she must be worth $x now. Prior pay can be especially helpful if it came from a company that the subject employee did not control at the time. In other words, it is more telling if the prior pay came from a third party and not from a company where the subject had the ability to set his own pay level. But even then, it is usually not that simple.
The Tax Court has examined this issue in several cases, including Choate Construction Company, T.C. Memo. 1997-495.
More words of caution: When it comes to finding comparability data, ensure that the industry data comes from reliable sources. Don’t believe all benchmarking data you find on the internet.
After carefully making market comparisons, you may find that your subject was paid above the average market amounts. But this may not necessarily mean that he or she received unreasonable compensation. After all, someone has to be above average, or it’s not an average.
Rather than focus entirely on paying median or mean market rates, I suggest focusing on some other questions: Did he or she provide above-average results? Are we getting what we pay for? Does the value we receive equal or exceed the cost? Could we somehow get more for our money?
If an individual is truly unique because of special skills, duties or spectacular results, then his or her compensation may need to be set by means other than comparability data. Some people are simply off-the-chart.
For more information on using comparability data to determine reasonable compensation, see www.ReasonableComp.biz
Stephen D. Kirkland CPA, CMC, CFC, CFF
Atlantic Executive Consulting Group, LLC
Stephen Kirkland is a compensation and tax consultant with over thirty years of experience.