4 - Do We Understand Executive Compensation Best Practices?

Summary

The rise in executive pay over the last four decades correlates with the rise of corporate governance. This chapter shows that the explosion in executive compensation has mostly been due to the adoption of two “best practices” urged on boards by the modern corporate governance regime: (1) the use of equity incentives to align managers’ interests with those of the shareholders; and (2) the adoption of pay-for-performance schemes. A large body of empirical research suggests neither of these compensation practices produces better corporate performance; the research does show, however, that these pay practices lead to adverse outcomes, including fraud. The chapter concludes by discussing how modern corporate governance’s focus on controlling agency costs has blinded it to the many other roles executive pay must play in a well-run organization.