Talking Points: Seven Myths of Executive Compensation

by Boardmember, July 2011.

David Larcker directs the corporate governance research program at Stanford School of Business and recently co-wrote the book, Corporate Governance Matters, with Brian Tayan. While the book covers a wide range of topics, Larcker joined Corporate Board Member to discuss and debunk his seven myths of executive compensation. Excerpts:

Corporate Board Member: Before we delve into myth-busting, why do you think criticism of CEO pay might be off the mark?
Dave Larcker: I think the public perception is achieved by some outrageous examples.  It’s good to step back and ask the question, what are the facts around this?  The other part of it is that boards are really trying to do a good job.  It’s a hard thing to do this kind of work and they’re professionals.  What we’re trying to do is take a step back and do the reality check; is everything messed up?  Let’s acknowledge that there are some bad characters out there but I don’t think it’s everybody, I don’t think everything is messed up.

CBM: Your first myth is that the ratio of CEO pay to average pay is a useful statistic; why do you think that’s not a useful statistic?
DL: I think it’s a very eye-catching statistic and the numbers are pretty big and it’s easy to make a graph of that and show it in an article.  It’s a piece of the puzzle, but I don’t think it’s the whole thing.  I think setting pay is a lot more complicated than just looking at the ratio of CEO pay to average worker pay.  I certainly will admit that I worry about the wealth distribution in the United States. On the other hand you want to be careful constraining the incentives embedded in CEO pay because that gives rise to the innovation and growth of these companies.  It’s dangerous just to collapse this very complicated topic into one simple ratio and then somehow magically come up with a number that it ought to be.

CBM: The second myth is that compensation consultants cause pay to be too high.
DL: They’re an easy target, but the truth of the matter is the board sets the pay.  The comp consultants make various recommendations but ultimately it’s a board decision.  If a board appears to have some governance problems, like the CEO has appointed all the board members, or the board members are on lots and lots of other boards, those are the kind of things that seem to be associated with excessive levels of pay, not whether you use a comp consultant or whether the comp consultant is also doing pension consulting for you.  So they’re an easy target, but it’s really a board decision.

CBM: That’s a valid point.  How about myth three, that we can easily identify compensation plans that cause excessive risk taking?
DL: As a result of Dodd-Frank companies have to make some discussion in the proxy with regard to how all plans provide incentive for excessive risk taking. It sounds like a good idea, particularly after the financial crisis.  The problem is, of course, the SEC has never defined what “excessive risk taking” means.  So I think what it means is you’re engaging in pure speculation, you’re just going for the wild outcomes regardless of whether it’s a good deal or not, like you’re in Vegas. I don’t think there is an obvious set of tools out there where you say, if I use stock options, I have excessive risk taking relative to a company that doesn’t use stock options.  But I think you have to look at the whole package deal.  You have to look at the character and characteristics of the executives; are they really risk averse or are they risk seeking? (continue reading… )

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