Relative Performance Benchmarks: Do Boards Follow the Informativeness Principle?

Abstract

Relative TSR (rTSR) is increasingly used by market participants to judge and incentivize managerial performance. We evaluate the efficacy, reasons, and implications of firms' benchmarks in rTSR-based contracts. Although compensation consultants suggest that a primary objective of rTSR is to filter shocks unrelated to managerial performance, following the informativeness principle, we document that a significant subset of firms, who choose index-based benchmarks, do not adequately achieve this objective. Further, the index-benchmark selection is associated with governance-related frictions, and not driven by plausible alternative theories. Both structural calibration and reduced-form estimates reveal significant negative performance implications from sub-optimal peer-selection.