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How To Beat The Bureaucrats!

Clinton, Congress, the IRS, and the FASB have set up new rules that unwittingly discourage pay-for-performance. But some compensation committees are finding ways to follow the rules and advance share holder interests.

We knew that defensiveness over CEO pay had reached new heights when one of the companies in our survey refused to verify its proxy-statement data, claiming: “We’re not allowed to participate in CEO surveys anymore.” The bureaucrats-chief causes of companies’ defensiveness-discourage compensation committees from using CEO compensation to advance shareholder interests. Their rules, both enacted and proposed, limit base salaries and restricted stock grants; mandate formula bonuses; prohibit the use of judgment; and disfavor stock options.

Compensation committees are reacting in three distinct ways. Some are giving up on pay-for-performance and resurrecting the old entitlement mentality. A few companies are continuing their old programs, but at the cost of lost tax deductions today and reduced book earnings in the future. Many companies, though, are out-smarting the bureaucrats by continuing to use CEO compensation as a vehicle for advancing shareholder interests.

In Chief Executive’s eighth annual survey of CEO compensation, we will: €.Explain why the bureaucrats keep interfering. (It’s not a socialistic attempt at wealth transfer.)

  • Show how more companies than ever are getting CEO pay “right” by linking it to shareholder interests, despite the barriers erected by the bureaucrats.
  • Shine a spotlight on the handful of companies that remain stuck in the old high-pay-for-low-performance habit.
  • Describe how some compensation committees comply with the new rules while still advancing shareholder interests.


Many CEOs believe that the bureaucrats develop destructive rules concerning executive compensation out of a socialistic desire to transfer wealth. This misses the point and weakens attempts to overrule the bureaucrats.

Most bureaucrats-whether on Capitol Hill, at the IRS, or the Financial Accounting Standards Board-mistakenly perceive the shareholder/CEO relationship as a zero-sum game, like the traditional buyer/supplier relationship. The buyer hires an agent-the compensation committee-but the agent colludes with the supplier, because he supplies the same services to other buyers and thus wishes to bid up the market price. The bureaucrats’ objective is to make it more difficult for the alleged collusion to occur.

We won’t even address the accusation of collusion, which is inconsistent with our own experiences in boardrooms over the last 20 years.

The fundamental flaw in the bureaucrats’ logic lies in their basic premise that CEOs and shareholders are engaged in a zero-sum game.

Intelligent shareholders view the CEO as their most important partner, i.e., the one with the greatest influence on economic performance. To maximize this influence, shareholders want their partner to share their economic interests, so both partners win or lose together. In addition, because both parties can exit the partnership, each partner pays the market price for the other’s services-competitive pay for the CEO’s labor and a competitive return for the shareholders’ capital.

These concepts rule CEO compensation today-a desire to align the economic interests of the shareholder and the CEO, and recognition that each partner requires a competitive return, either of labor or capital, to remain in the partnership. The Securities and Exchange Commission understands this, which explains why its rules deal with disclosure. The other bureaucrats’ zero-sum rules, focusing on pay design and pay levels, just get in the way.


From a shareholder’s point of view, the partnership worked well in 1993. While total performance pay (including the expected value of stock-based compensation) increased in 11 industries, it declined in five others. Generally, the gains and losses reflected shareholder returns for the industry. For example, shareholder returns in the aerospace industry averaged 30.6 percent in 1993, and CEO compensation grew 31.7 percent. The pharmaceuticals industry illustrated the reverse, with one-year shareholder returns of -6.6 percent and a 13.9 percent decline in CEO compensation. The magnitude of these swings in compensation is healthy, because it reflects the strong alignment of interests between the partners. (Exhibit I compares 1992 and 1993 competitive compensation levels for each industry.)

Our analysis of pay leverage (see Exhibit II) shows how today’s compensation committees link CEO returns to shareholder returns. Our Leverage Index measures the sensitivity of the CEO’s pay package to a doubling in the company’s stock price. An index of 2.00 means the CEO’s earnings would double; 1.50 indicates they would increase 50 percent; and 1.00 means they would remain unaffected. Every compensation committee should aim for a CEO leverage index of at least 2.00, regardless of industry.

Compensation committees have made outstanding progress toward this goal over the last two years. This year, 49 percent of the 238 companies in our survey had a CEO Leverage Index above 2.00, compared to 44 percent in 1992 and 33 percent in 1991. This is a roughly 50 percent increase in just two years. Low-leverage companies-those below 1.50-similarly have declined, from 44 percent in 1991 to 32 percent in 1993. Shareholders are the real winners, because their partners now are paid to work on their behalf.

Compensation committees are giving their CEOs a powerful message: “Enrich shareholders, and you will gain great wealth.” Nor is this a “carrot-only” approach, as the gadfly critics and bureaucrats assert. Total performance pay declined at 39 percent of the companies in our survey. Some low-performing industries were hit hard, such as food and beverage, where CEOs in 16 of the 24 companies experienced pay declines.

Compensation committees also are insisting that CEOs hold on to the shares they receive. Over 10 percent of the surveyed companies articulated their ownership guidelines in their proxy statements. Direct questioning indicates that upward of 25 percent have such policies. All companies should describe their ownership guidelines in their proxy Many companies encourage ownership through innovative means that benefit executive and shareholder alike. Travelers, the Hartford, CT-based financial-services company, requires executives to exchange a designated percentage of cash compensation (salary plus bonus) for restricted stock.

The exchange percentage increases in proportion to the level of total cash. A 25 percent “purchase discount” compensates for the risks and illiquidity of the two-year vesting period.

Minneapolis-based General Mills, a longtime innovator in ownership-focused compensation, continues to implement new programs that commit employees to a shareholder-value orientation. Its proxy statement articulates two key goals-employee ownership equal to 10 percent of shares outstanding, and share ownership by 90 percent of all employees with three years of tenure.

To help achieve these objectives, General Mills uses a variety of programs. As has been the case for several years, almost 300 executives voluntarily forgo future salary increases and receive additional stock options. The company also matches every share an executive puts “on deposit” (and thus cannot trade) with a restricted share that vests over six years. A third program enables executives to deposit additional shares, worth up to half the year’s bonus, and receive two options (that vest after three years) for every share. And a new stock option plan provides for grants to all 50,000 employees with more than three years of tenure. True to the board’s shareholder-value focus, dilution is minimized by coordinating the new option plan with the company’s stock-repurchase program.

When it came to CEO ownership guidelines, recently acquired Gerber Products of Fremont, MI, was perhaps the most aggressive company in our survey. The proxy statement compared actual and targeted ownership levels for the top five executives. CEO Alfred A. Piergallini was expected to own company stock worth 10 times his total cash compensation.

Over the years, the compensation committee enacted several programs to help Piergallini and others meet the aggressive targets. First, he could exchange up to 100 percent of his bonus each year for shares of stock. The share total was increased 4 percent each year for five years, as long as he retained all the shares received in the exchange. He also received one restricted share for every option granted; he forfeited the restricted share if he sold the option share upon exercise. Nor could the committee be accused of piling riches upon riches. Piergallini’s 1993 total cash compensation of $506,000 was below competitive practice, and the options he received in late 1993 carried exercise prices above fair-market value because of the company’s poor stock performance in 1993. Could all these ownership inducements have inspired Piergallini to negotiate better than a 50 percent acquisition premium on Gerber’s stock price?


High-leverage ownership programs, such as the ones at Travelers, General Mills, and Gerber, work so well, because they result in CEO risk profiles that match those of his or her partners, the shareholders. But too many compensation committees today still provide CEOs with plenty of upside opportunity but limited downside risk.

New York-based Time Warner has been playing the “win big if you fail, win very big if you succeed” game for years. At first glance, CEO Gerald Levin’s 1 million-share option grant appears to reflect shareholder interests. Half the options carry exercise prices up to 50 percent above fair-market value. But the award comes on top of a salary in excess of $1.1 million and a $4 million bonus. Both are well above competitive practice, even in the high-paying publishing and broadcasting industry. Levin’s partners, the shareholders, have averaged returns of 10.7 percent per year over the last four years-decent but not outstanding. Do both sides face the same risks?

At Dole Food in Westlake Village, CA, CEO David Murdock wins big, no matter how other shareholders do. If Dole’s stock takes off, Murdock will win big, as shown by his leverage index of 2.53. But he did so in 1993 anyway, with base salary and total cash compensation exceeding competitive practice by 62 percent and 55 percent, respectively. This is difficult to understand, given Dole’s 1993 return to shareholders of -15.5 percent and 1990-to-1993 annualized return of -5.2 percent. Murdock is also a major shareholder in Dole Foods-was the compensation package designed to make up for his losses as a shareholder?


The question is: How can compensation committees encourage CEOs to be good partners and still comply with the bureaucrats’ new rules? Many companies in our survey have discovered creative solutions that preserve full tax deductions, enable compensation committees to exercise judgment, out-flank today’s FASB rules, and prepare for possible future FASB rules.

The $1 million cap on deductibility of CEO compensation ignores competitive pay realities. But enterprising companies use deferred compensation programs to circumvent the rules. Edward Brennan of Chicago-based Sears Roebuck & Co. voluntarily deferred all salary payments above $1 million until after his retirement. New York-based AT&T’s proxy statement suggests that its deferral program delivers competitive levels of compensation while preserving full tax deductibility.

Nothing more clearly demonstrates the IRS bureaucrats’ belief in the collusion myth than the Tax Code’s insistence that bonuses be formula-based in order to qualify for an exemption to the $1 million cap. By doing so, the IRS bureaucrats are attempting to stop committee members from exercising judgment. But didn’t shareholders elect them to exercise judgment?

Shrewd compensation committees, like those at Chicago‘s UAL; Madison, NJ-based Schering-Plough; and Olin in Stamford, CT, are beating the bureaucrats at their own game. Their formulas set maximum bonus payouts, which committees can use their discretion to reduce. This loophole will be very difficult for the IRS to close-how can it force a company to pay full-formula awards, even if its compensation committee wishes to pay less?

Another IRS requirement for the exemption to the $1 million cap, designed to stop the alleged collusion, is for option plans to state the maximum award any individual can receive. This reduces a compensation committee’s ability to respond to special circumstances, such as recruiting a prospective new CEO.

The rules do not specify a time period, so Indianapolis-based Eli Lilly’s plan permits a three-year maximum of 750,000 options. By stretching the time period, the compensation committee minimized the effect of any single year’s grant, thus preserving its flexibility in the face of special situations.

Compensation committees also are fighting back against the FASB’s rulemakers. Current FASB rules disfavor options with performance-based vesting schedules by treating them as variable (and thus subject serve to an shareholder earnings charge), although better they than time-based vesting schedules.

Some companies have exploited a loophole in the FASB rules that permits performance-based acceleration of time-based vesting schedules, without tiggering an earnings charge. The program at Times Mirror, the Los Angeles-based publishing company, is a model example. CEO Robert F. Erburu’s 100,000 stock options, granted in 1993, expire in 10 years. Unlike most awards, though, they are not exercisable until three months before expiration. This brief exercise window greatly reduces their value. But Erburu can accelerate the vesting schedule to three years (and lengthen the exercise window to seven years) by achieving designated performance objectives over the first three years.

The most frustrating bureaucratic decision is the FASB’s proposal to expense stock options. Opponents range from shareholder-rights groups and employees of high-tech companies to Treasury Secretary Lloyd Bentsen and Connecticut Senator Joseph Lieberman. Yet the FASB’s bureaucrats keep parading their zero-sum view of the shareholder/CEO partnership.

Many compensation committees are struggling to prepare for the proposed rule’s enactment. A few, however, appear to be exploiting the delay in implementation by making extra-large grants of options today. Otherwise, it is difficult to explain some of 1993’s year-over-year increases in stock-option grants, such as those of Troy, MI-based Kmart’s. J.E. Antonini (20,000 to 125,000 shares); Bethesda, MD-based COMSAT’s Bruce L. Crockett (21,425 to 200,000 shares), or Richard L. Gelb of New York-based Bristol-Myers Squibb (86,000 to 215,000 shares).


Some critics claim that the bureaucrats have no constructive role to play in the executive-compensation debate. We disagree. The bureaucrats’ job is to facilitate the free flow of information, so that informed compensation committees, CEOs, and shareholders-all partners-can make the best possible decisions.

We tip our hat to the SEC, whose new rules require candor in describing both the “what” and “why” of CEO compensation packages. While we don’t agree with all the proxy-disclosure rules, they do help ensure the free flow of information between the partners. The SEC pushes no agenda, be it zero-sum games, alleged collusion, wealth transfer, or discredited accounting theories. As a result, most compensation committees carry out the SEC rules without resorting to loopholes.

Bureaucrats as facilitators, not legislators-is it too much to ask?


CEO pay data for the most recent fiscal year were analyzed from annual reports and proxy statements for a sample of 238 companies that represent a cross section of small, medium, and large companies, and low, medium, and high performers in 16 separate industries. Our analysis is based on the CEO as of the close of the company’s fiscal year.

Company Performance equals annualized total return to shareholders for the 1990 to 1993 period. (As a simplifying assumption, dividends are not “reinvested,” unless significant payouts have resulted from capital restructuring.)

Competitive Pay is calculated through regression analysis (“lines of best fit”), comparing revenues with CEO pay for each company in an industry group.

Actual Pay is salary, annual bonus, and the expected value of long-term incentives:

  • Options are valued using the “extended” binomial method. We adjust this calculation as follows: We discount option values 25 percent for illiquidity and for the risk of forced early exercise following termination. We discount the option value 5 percent per year over the weighted average vesting period to reflect forfeiture risk. If the proxy statement does not disclose vesting, we assume an average vesting of three years.
  • Restricted shares are assigned face value, discounted 5 percent per year for the average vesting to reflect forfeiture risk. If the proxy statement does not disclose average vesting, we assume five years and discount 25 percent.
  • Performance units and performance shares are valued at target, discounted to reflect forfeiture risk like restricted shares. If performance shares are at maximum, we discount an additional 25 percent for performance risk.

This valuation approach captures the expected value of long-term incentives at the time of grant.

Pay Factor is the percent difference between Actual and Competitive Pay.

Performance Factor is determined by subtracting the median Industry Performance from Company Performance.

Return Above/(Below) Industry is the difference between the growing market value of the company at the Company Performance rate versus the Industry Performance rate.

Pay Above/(Below) Competitive is the dollar difference between Actual and Competitive Pay.

Pay Premium (Penalty) per $100 in Performance is calculated by dividing Pay Above/(Below) Competitive by Return Above/(Below) Industry/$100.

NM relates to companies in which pay and performance are not aligned. Linkage is absent.

Leverage Index is the ratio of Actual Pay assuming a 15 percent annual stock price growth rate, and Actual Pay assuming a 0 percent annual stock price growth rate.

CEO Capitalization Index is a measure of ownership calculated in the same way as the Leverage Index, except that the numerator includes the appreciation in value of all options and shares held.

Jack L. Lederer is founder and chief executive of COMPO Consulting Group, a Norwalk, CT-based management consulting firm specializing in compensation, organizational effectiveness, and executive development.

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