Wednesday, June 1, 2011

7 Myths of Executive Compensation

Corporate governance experts from Stanford Graduate School of Business say criticism of CEO pay might be off the mark.

STANFORD GRADUATE SCHOOL OF BUSINESS — "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?'"
Myth #4: The performance targets in the compensation plan tie directly to the strategy.
"Many companies have adopted complicated bonus plans whose target values depend on achieving a variety of financial and nonfinancial targets," says Tayan. "The assumption is that these targets map directly to the corporate strategy. But evidence suggests that not all companies do a good job of making this connection. It is a very difficult assessment, and requires testing the relationship between performance drivers and actual operating results – something that is not common in boardrooms today. Companies also tend to overemphasize the financial metrics and underemphasize nonfinancial metrics that might be the real indicators of future performance."
Myth #5: Eliminating discretionary bonuses is a good idea.
"Sometimes when a company misses its performance targets, the board may decide to give what is called a 'discretionary' bonus to the CEO anyway," explains Larcker. "The perception is that these bonuses are always bad because they reflect pay that was 'unmerited.' The truth is that there are times when external factors, such as an economic downturn or change in industry conditions, reduce company performance. What the board needs to assess is whether the company still performed above expectations, even though these unexpected factors occurred. If it did, the board should reward that individual."
Myth #6: Proxy advisory firms know how to evaluate compensation contracts.
"Following Dodd-Frank, companies are now required to allow shareholders to cast an advisory vote on whether they approve of the executive pay packages – this is known as 'say on pay,'" says Tayan. "Proxy advisory firms are heavily influential in this vote, but it is not at all clear that their rigid guidelines are in the best interests of shareholders. For example, they automatically vote against a company if they allow things such as option exchanges that are not approved by shareholders, very large severance agreements, or tax gross ups on certain benefits or payments. These restrictions might be arbitrary and might not be appropriate for a specific company."
Myth #7: The numbers reported in the financial statement for stock option expenses are a good approximation of their cost.
"Companies award stock options because they want to give executives incentive to create long term value, and the cost of these grants are required to be included in financial statements and the annual proxy," says Larcker. "The truth is that we do not know the true cost of executive stock options. The current models do not take into account human behavior, such as the propensity of executives to exercise their options early when they are 100% in the money. The board would clearly benefit from more precise valuation models that more closely measure the cost to firm and the value to the executive."

"In the rush to assign blame for the financial crisis, it's easy to point to the all the big numbers in top executive compensation plans," says Larcker. "But the truth is a lot more complicated."