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7 Myths of Executive Compensation (Press Release)

7 Myths of Executive Compensation (Press Release)

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

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05/14/2012

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 FOR IMMEDIATE RELEASE: June 15, 2011Contact:
Helen Chang, Stanford Graduate School of Business, 650-723-3358,chang_helen@gsb.stanford.edu 
7 Myths of Executive Compensation
Board experts from Stanford Graduate School of Business sayCriticism of CEO pay might be off the markSTANFORD, CA ² ³Executive compensation may be the lightning rod for shareholders in the wake of the financial crisis, but the truth about how payshould be structured is clouded by a lot of popular myths,´
says
David Larcker 
,who is James Irvin Miller Professor of Accounting and Director of theCorporateGovernance Research Programat theStanford Graduate School of Business. He is coauthor of the new book
Corporate Governance Matters
(FT Press).³Boards have been put on the defensive when it comes to comp, but the problems thatcritics are offering solutions to aren¶t that cut and dried,´ explains
Brian Tayan
, Larcker¶scoauthor 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.
³Dodd-Frank requires that companies disclose the ratio of CEO pay to that of theaverage worker,´ says Larcker. ³But in certain companies, high pay packages may benecessary, and in certain industries ± such as retail ± the ratio may be much higher thanin other industries, such as investment banking. Boards have to consider that how muchthey 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 avoidscrutiny over how much they are paid.´
Myth #2: Compensation consultants cause pay to be too high.
³The perception is that compensation consultants are beholden to management,´ saysTayan. ³But research shows that it is not the compensation consultant or whether thecomp consultant is conflicted that drives excessive pay levels. Instead, it is thegovernance 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.
³It is commonly accepted that the structure of executive compensation contractsencouraged the excessive risk-taking leading to the financial crisis,´ says Larcker. ³As aresult, Dodd-Frank now requires companies to discuss the relation betweencompensation and risk. The reasoning may be valid, but we simply do not yet know howto measure the relationship between compensation and excessive risk-taking in anyprecise way. How many boards can go through their plans and say, µThis featurecauses risk-taking, but this one does not?¶´
Myth #4: The performance targets in the compensation plan tie directly to thestrategy.
³Many companies have adopted complicated bonus plans whose target values dependon achieving a variety of financial and nonfinancial targets,´ says Tayan. ³Theassumption is that these targets map directly to the corporate strategy. But evidencesuggests that not all companies do a good job of making this connection. It is a verydifficult assessment, and requires testing the relationship between performance driversand actual operating results ± something that is not common in boardrooms today.Companies also tend to overemphasize the financial metrics and underemphasizenonfinancial metrics that might be the real indicators of future performance.´
Myth #5: Eliminating discretionary bonuses is a good idea.
³Sometimes when a company misses its performance targets, the board may decide togive what is called a µdiscretionary¶ bonus to the CEO anyway,´ explains Larcker. ³Theperception is that these bonuses are always bad because they reflect pay that wasµunmerited.¶ The truth is that there are times when external factors, such as aneconomic downturn or change in industry conditions, reduce company performance.What the board needs to assess is whether the company still performed aboveexpectations, even though these unexpected factors occurred. If it did, the board shouldreward that individual.´
Myth #6: Proxy advisory firms know how to evaluate compensation contracts.
³Following Dodd-Frank, companies are now required to allow shareholders to cast anadvisory vote on whether they approve of the executive pay packages ± this is knownas µsay on pay,¶´ says Tayan. ³Proxy 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 asoption exchanges that are not approved by shareholders, very large severanceagreements, or tax gross ups on certain benefits or payments. These restrictions mightbe arbitrary and might not be appropriate for a specific company.´
Myth #7: The numbers reported in the financial statement for stock optionexpenses are a good approximation of their cost.

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