09/30/2009 05:12 am ET | Updated May 25, 2011

Ratcheting Up CEO Pay -- Or Competing For Talent?

If you were on the compensation committee of a public company board how would you set the CEO's pay?

There is so much written about fat cat CEOs and their unfair pay packages that this is a question worth pondering (if you care). The really hard part about it is judging what is a) fair, b) necessary to get the talent you want and c) the market.

One tool compensation committees use is the "peer group." This is the list of companies that are "like" your company. They are supposed to be similar in size, similar in market reach, something you can compare with to figure out what your CEO should be paid. But as the Wall Street Journal points out recently, the very use of the peer group can cause CEO pay to ratchet up.

The problem goes like this. Most companies are planning to grow and want to have a CEO that can grow the company and make it larger and more competitive. As a result, they pick peer groups that, while they have some companies that are smaller, include many companies that are larger, and have higher paid CEOs than the current executive -- two studies cited by the Journal confirm this. (The SEC only started requiring companies to publish their peer groups in 2006, so there is now enough data for the pundits and researchers to start to dig.)

At the same time, over 40 percent of companies say that they want to pay their CEO's above market average -- numbers like 60 percent and 75 percent of market are often used.

So, if your peer group is larger companies where the CEO pay is higher, and you want to pay your CEO above market, you will take CEO pay up. It's a compounding phenomenon.

Sounds like a conspiracy, right? Well, sitting on two very quality compensation committees, I can tell you from experience it isn't. It's a very real challenge for boards to figure out the right level of pay. High enough to attract a great CEO who can take the company on the growth journey you want (which takes both smarts and courage) and not so high that it hurts the financial results of the company or creates too great a gap to other executives and the employees.

The good news is the peer group is just one tool we use. We also look carefully at internal executive pay to make sure we are not creating an internal problem, and more importantly at the job the CEO is doing and how he is conquering our strategic objectives.

Most senior executives' compensation is now made up of three major components -- base salary, variable bonus based on company performance, and some form of stock (stock options or restricted stock grants). Having these levers allows the board to align the CEO's pay directly with the interest of the shareholders. This has happened to most technology companies over the last year -- there are very few bonuses being paid because performance hasn't been there as a result of the recession.

Of course you do still see companies that offer their CEO compensation that doesn't seem very aligned to shareholder interest to me: use of the private jet, special health care, tax advice, golf club membership, etc. -- and even a key to the executive washroom. Something I don't understand, but I guess I am an egalitarian when it comes to building company culture.