How Good are Our 'Best Practices' When it Comes to Executive Compensation? A Review of Forty Years of Skyrocketing Pay, Regulation, and the Forces of Good Governance

Abstract

The recent growth in executive compensation plays a significant part in discussions of corporate governance. The dominant narrative uses agency cost theory to explain executive pay in terms of self-dealing executives and directors too weak or conflicted to stop them. The wide-spread acceptance of this explanation supports an industry of corporate governance advisors, as well as justifying activist shareholder campaigns and regulatory interventions.

In fact, the actual cause of the increase in executive compensation over the past four decades has been the increasing use of equity incentives and pay-for-performance schemes. These constitute the “best practices” promoted by shareholders and governance activists over the relevant time period. Empirical studies conducted on these pay practices suggests there is little evidence they improve corporate performance and considerable evidence they produce a variety of deleterious effects.

The most obvious solution is to increase board autonomy in setting pay. Indeed, the narrowness of the best pay practices promoted by the governance industry reflects a lack of sophistication both about incentives and the variety of real-world factors relevant to corporate compensation structures.

Keywords: Executive pay, remuneration, compensation, corporate governance, corporate law, securities regulation, proxy advisors

JEL Classification: K22, G30