Executive Compensation Peer Group Selection

Picking an executive pay peer group is how boards justify CEO and senior executive salaries. But the process contains a ratcheting mechanism: companies tend to target pay at or above the median of their peers, and peer groups themselves creep upward in size and expense each year, creating systematic upward pressure on executive compensation regardless of company performance.

How Peer Groups Are Constructed

A compensation peer group is a curated list of companies the board believes are true comparables for executive talent and business complexity. The compensation committee—typically independent directors—works with an external pay consultant (firms like Mercer, Willis Towers Watson, or Pearl Meyer) to assemble the group.

The selection process starts with industry and size filters. A software company with USD 5 billion in revenue might look at other software, cloud, and enterprise technology firms in the USD 2–8 billion range. A financial services firm might include regional banks, asset managers, and insurance companies of similar scale. The committee also considers business model (are they subscription or transactional?), customer concentration, margin profile, and growth stage.

Once candidates are identified, the board applies subjective judgment. Does the peer face similar competitive pressures for talent? Does it operate in similar geographies? Is the business complexity comparable—does the peer need the same caliber of chief technology officer or chief financial officer? A USD 3 billion pharmaceutical company might exclude smaller biotech firms and instead benchmark against larger, diversified healthcare companies, even if they have different revenue.

The result is typically a group of 15–30 companies. Smaller companies may benchmark against 12–15 peers; larger ones against 30+. The exact composition matters: a single peer selection can justify a difference of 20–30% in the target salary.

The 50th Percentile Target and Above

Once the peer group is set, the compensation committee uses it to set a pay philosophy. The most common target is the median (50th percentile): the board aims to pay the CEO at or near the median of peer group salaries. Some boards target the 75th percentile if they want to be competitive for “top talent” or if the company performed well; others use the 25th percentile if capital is scarce.

This philosophy has a built-in bias toward the median or above. Few boards say “we pay at the 40th percentile.” The result is that most executives end up earning close to or above market median—and across an entire market, that’s mathematically impossible unless everyone is above median. The constraint is resolved by peer-group drift: median peers grow richer, larger, and more expensive, so the benchmark itself rises.

Peer-Group Inflation: The Ratchet Mechanism

Here is where systematic upward pressure enters. Peer groups are not static. Every few years—or annually—the board revisits the composition. Some original peers may be delisted, acquired, or no longer comparable (their business changed). New peers are added to keep the group fresh and relevant.

But there is a directional bias in these updates. A peer company that was acquired at a premium or merged upward typically leaves the group; it is replaced by another company in the same revenue class. Over time, this tends to include newer companies with higher valuations, more growth, and higher executive compensation. A peer group of “USD 3–5 billion software firms” from 2015 included different companies than one assembled in 2023; the newer cohort likely had higher pay.

Additionally, peers themselves are growing and expanding. The USD 5 billion revenue company that was in the peer group five years ago is now USD 7 billion. Larger firms generally pay more. If the target peer group is updated annually and peers are drifting upward in size or pay, the benchmark drifts upward too.

A compensation committee that has not consciously changed its philosophy—it still targets “median peer pay”—will nevertheless approve higher compensation each year if the peer group itself is growing. This is the ratchet effect: upward pressure on pay that does not depend on board decisions to be more generous, only on the slow, invisible drift of peer composition.

Criteria for Peer Selection

Compensation committees typically document their peer-selection methodology in the proxy statement (the annual filing to shareholders). Common criteria include:

Industry and business model. Same or related industry; comparable product or service delivery (software-as-a-service, transactional banking, manufacturing, etc.).

Financial size. Often expressed as a range (USD 2B–8B revenue, or USD 10B–50B market cap). Some committees use revenue; others use market cap, assets, or EBITDA depending on the business.

Growth profile. A high-growth startup company may use a peer group of other venture-backed or rapid-growth firms, even if larger by revenue.

Geographic scope. A US-focused company might exclude heavy international operators or vice versa.

Complexity and business scale. Number of employees, geographic footprint, product lines, and organizational structure. A conglomerate with five divisions might benchmark against other diversified companies, not pure-play specialists.

Market cap or profitability profile. Some committees match on profitability to exclude distressed peers.

Public companies must disclose their peer group in the proxy statement (typically in the Compensation Discussion & Analysis section), and shareholders can and do scrutinize it. Activist investors sometimes challenge peer group composition if it appears inflated or irrelevant.

Peer Groups as Justification, Not Constraint

Once assembled, the peer group serves a legal and governance purpose: it provides a defensible benchmark for pay decisions. If a shareholder or regulator questions why the CEO received a USD 20 million package, the board can point to the peer group and say “median pay at our comparables was USD 19 million, so we are at-market.”

This framing is comforting to boards and insulates them from claims of excessive pay. It also aligns with the principle of competitive pay: the board wants to attract and retain talent, and if peers are paying USD 19 million, the company must too. That logic is hard to fault in a competitive labor market.

However, the peer group is rarely a hard constraint. If the board has decided to attract a superstar CEO or reward performance, it can set a higher target (75th percentile) or even pay above all peers. The peer group provides a reference point, not a ceiling or floor.

Cross-Check and Disclosure

Compensation committees often use multiple benchmarking approaches to cross-check the peer group analysis. They may compare pay levels to public data from surveys (e.g., BNA, Equifax), to peer-group medians, and to one-off analysis of named executive officers at very similar companies. Large proxy advisory firms like ISS and Glass Lewis scrutinize the disclosed peer group, and so do major institutional investors.

Criticism of peer groups is common. Investors have challenged committees for cherry-picking high-paying peers, for including much larger or smaller companies in the group, or for updating the group in ways that systematically inflate the benchmark. Some shareholders argue that peer groups justify excessive pay by allowing upward ratcheting without explicit merit or performance justification.

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