Does the use of consultants to advise on CEO compensation increase CEO pay?

What is it about?

We use a regulatory change that affected the use of consultants to advise on pay and examine firms that shifted from one type of consultant to another. This allows us to determine which types of firms hire consultants for what reason and which types of consultants are hired to just increase pay.

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Why is it important?

In the last few years, CEO pay has attracted a lot of attention because the pay gap between CEOs and other employees has risen quite dramatically. But what causes a CEO pay increase? One possibility is because boards hire consultants to advise them on pay. And consultants will advise higher pay if they in turn, are compensated by the management of the firm. However, it has been difficult to understand whether the use of compensation consultants actually causes pay increases for the CEO of the firm who hired the consultant. This is because of a problem called endogeneity. The endogeneity problem occurs when there are hidden factors that might produce the same result (consultant use is associated with high pay) but are not taken into account in the analysis. For example, suppose a CEO hires a consultant and gets a pay increase. Did the consultant cause the pay increase? The consultant is honest - she will only recommend high pay if the CEO deserves it. So the CEO makes the business so difficult to understand that no one (including the consultant) can figure out what is going on. Or the CEO, through no fault of his own, is dealing with an extraordinarily complicated business and deserves to be paid more for handling this complexity. So in this case, the real cause of the pay increase is not the consultant but the complexity of the firm. In this paper, we devise a way of handling this endogeneity issue that depends on a change of regulations imposed on all firms in the US.