Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms

Two landmark episodes of the last decade, the 2001 dot‐com crisis and the 2008 bursting of the housing bubble, have drawn attention to the size and structure of executive pay plans and their possible role in propagating or worsening the crises. In this policy‐oriented piece, the authors discuss the key issues in the debate on executive pay and express their support for a number of reform proposals that have been advanced in academic and policy circles. The article begins by dividing the compensation debate into four key issues: First, while public outrage has focused on the size of the pay packages at failed financial institutions, it is perhaps more important to focus on the structure of compensation and the process of setting compensation to prevent future crises. An effective pay package is not necessarily the one most laden with equity incentives. Too much equity exposure can cause excessive risk‐taking, manipulation, and shift executive attention away from true value creation. Second, incentive structures should incorporate indexing and clawbacks to guard against the possibility that performance benchmarks are rewarding luck more than sustainable, long‐run performance. Third, the compensation‐setting process should be placed in the hands of shareholders, boards, and advisors who are not only independent but also possess ample expertise in the financial instruments used to incentivize pay. Fourth and finally, any proposals for changes in compensation design or the taxation of compensation should anticipate how executives will alter their behavior in response to the changes, and evaluate the effect of the changes net of such offsetting responses.