7 Myths of Executive Compensation

by David Larcker and Brian Tayan for  Business Wire, June 15th, 2011.

Board experts from Stanford Graduate School of Business say Criticism of CEO pay might be off the mark.

“Executive compensation may be the lightning rod for shareholders in the wake of the financial crisis, but the truth about how pay should be structured is clouded by a lot of popular myths,” says David Larcker, who is James Irvin Miller Professor of Accounting and Director of the Corporate Governance Research Program at the Stanford Graduate School of Business. He is coauthor of the new book Corporate Governance Matters (FT Press).

“Boards have been put on the defensive when it comes to comp, but the problems that critics are offering solutions to aren’t that cut and dried,” explains Brian Tayan, Larcker’s coauthor and a researcher at Stanford GSB.

The 7 Myths of Executive Compensation

Larcker and Tayan’s research exposes seven common myths around compensation:

Myth #1: The ratio of CEO pay to that of the average worker is a useful statistic.

“Dodd-Frank requires that companies disclose the ratio of CEO pay to that of the average worker,” says Larcker. “But in certain companies, high pay packages may be necessary, and in certain industries – such as retail – the ratio may be much higher than in other industries, such as investment banking. Boards have to consider that how much they pay will have an impact on the types of people who want to take the CEO position. You don’t want to drive talented CEOs out of public companies so that they can avoid scrutiny over how much they are paid.”

Myth #2: Compensation consultants cause pay to be too high.

“The perception is that compensation consultants are beholden to management,” says Tayan. “But research shows that it is not the compensation consultant or whether the comp consultant is conflicted that drives excessive pay levels. Instead, it is the governance of the firm. Pay becomes too high if the board members are personal friends of the CEO, appointed by the CEO, or highly busy (in terms of total number of board appointments), etc.”

Myth #3: We can easily identify compensation plans that cause excessive risk-taking.

“It is commonly accepted that the structure of executive compensation contracts encouraged the excessive risk-taking leading to the financial crisis,” says Larcker. “As a result, Dodd-Frank now requires companies to discuss the relation between compensation and risk. The reasoning may be valid, but we simply do not yet know how to measure the relationship between compensation and excessive risk-taking in any precise way. How many boards can go through their plans and say, ‘This feature causes risk-taking, but this one does not?’” (continue reading… )

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