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Is CEO Comp Criticism Valid?

Long a popular pursuit in union halls and at Green Party gatherings, criticism of CEO compensation now has become a mainstream cause célèbre in America. The ideological din accusing company chieftains of raking in corrupt levels of pay and benefits has reached unprecedented levels-and is finally leaching into corporate governance itself.Beneath the rising public fever …

Long a popular pursuit in union halls and at Green Party gatherings, criticism of CEO compensation now has become a mainstream cause célèbre in America. The ideological din accusing company chieftains of raking in corrupt levels of pay and benefits has reached unprecedented levels-and is finally leaching into corporate governance itself.

Beneath the rising public fever on this issue, there’s a cool truth: CEO pay overall simply hasn’t exploded to irresponsible or even just outlandish levels. In fact, it has risen only relatively modestly over the last few years. And, based on their companies’ robust re – turns to shareholders, it’s even possible to argue that big-company CEOs in the U.S. haven’t been getting nearly the rewards they deserve.

Consider the latest annual compensation study by Mercer Human Re – source Consulting: While the median change in CEO total direct compensation was 8.9 percent last year at the 350 large public companies surveyed, corporate net income increased by a much larger 14.4 percent, up from 13 percent in 2005, and total shareholder return was 15.1 percent, more than double the 6.8 percent of 2005. Meanwhile, the increase in total cash compensation for constant, incumbent CEOs was 7.1 percent-the same rate as in 2005.

What’s more, today’s CEO compensation packages are usually closely aligned with performance. That’s why there has been little squawking, for example, over the $10 million pay package for Mark Hurd, the CEO who doubled the market capitalization of Hewlett-Packard and restored the company to computer industry primacy over Dell. Neither has there been much grumbling over Bank of America CEO Kenneth Lewis’s 2006 pay package of $28 million, or over his exercising $77 million in options- because the company’s shares surged more than 13 percent last year.

“The U.S. executive-pay model is working extremely well in that there’s robust pay for performance, and it has created enormous amounts of shareholder value,” asserts Ira Kay, executive-compensation consultant for Wat son Wyatt, New York, and coauthor of a new book, The Myths and Realities of Executive Pay.

A Seller’s Market

These realities offer a beacon of hope for board members and others who must cut through public criticism of CEO compensation and actually determine what corporate chiefs get paid. Despite the controversy over pay, the marketplace continues to acknowledge the special and often rare talents that CEOs bring, rewarding them for their leadership of high-performing companies and turning around of corporate laggards.

“Running a public company is a difficult endeavor that can only be done by a select few people, just like the few who can win a Masters Golf Tournament,” says Robert Shillman, who, as founding CEO of Natick, Mass.-based Cognex, hasn’t taken a salary for many years. “It’s still a seller’s market when it comes to CEOs.”

Another CEO, David Brandon of Domino’s Pizza, Ann Arbor, Mich., points out that “market principles apply” to CEOs “as well as to nurses and teachers. To a large degree, organizations are going to pay for available talent based on market demand. This obsession with CEO pay is interesting, but at the end of the day, boards will do what they have to do.”

What boards must do, directors agree, is ensure that the best hand is at the helm. “You can make a case against some of the really nasty [compensation] abusers, but if you need someone badly enough-and it’s the board’s job to find these people-you end up having to pay,” says George Wells, a director of Qlogic, a veteran of more than 20 boards, and one of the architects of Silicon Valley.

At the same time, astronomical severance packages-including Robert Nardelli’s lucrative exit from Home Depot, Hank McKinnell’s expensive ouster from Pfizer, and Richard Grasso’s chart-busting departure from the New York Stock Exchange-have made the topic an easier target for outrage. The options-backdating scandal uncovered by The Wall Street Journal added to the feeling that CEOs and compliant boards rig the game wildly to the chieftains’ advantage.

The fact that pay growth for most CEOs continues to far outpace everyone else’s also fuels the controversy. The Mercer study found that white-collar employees at 350 large companies got only a 3.7 percent pay increase last year, on average, compared to the 7.1 percent bump for sitting CEOs.

Saying Yes to “Say On Pay”

Sensing a potential populist issue, Democrats led by Rep. Barney Frank of Massachusetts pushed a “say on pay” bill through the House of Representatives in April, calling for advisory shareholder votes on top-executive compensation. Presidential candidates are taking their shots too: Hillary Clinton has called for greater public scrutiny of CEO pay, and Barack Obama has promised to introduce a say-on-pay bill in the Senate.

Greater requirements for overall corporate financial transparency are also magnifying the focus on CEO compensation. The Securities & Ex change Commission’s new rules on corporate disclosure of fringes now re quire companies  to reveal top-executive perks adding up to $10,000 or more apiece, replacing the old reporting floor of $50,000 each.

Activist shareholders are also beating their drums. Consider Verizon. Progressives have been squeezing the board of the big telco on executive pay and other issues for nearly a decade. In 2003, 59 percent of shareholders agreed that any executive severance agreement of more than 2.99 times base pay plus bonus had to go to shareholders for a vote. Last year, investors upped the pressure by adopting a rule requiring directors to win a majority of votes cast instead of a simple plurality.

The company’s moves this year to trim pensions and health care benefits for white-collar retirees-while CEO Ivan Seidenberg raked in $23.7 million in total compensation last year-fueled still more resentment. Meanwhile, the stock price has actually sagged since Seidenberg became sole CEO in 2002, dragged down by an easing of profitability over the last three years as the New York-based company digested MCI and other competitors.

“If [retirees] are being asked to tighten their belts to help the company, I don’t have a problem with that-but the top of the house should be leading by example,” says C. William Jones, president of the Association of BellTel Retirees, a 100,000-member organization. In the spring, the activists’ say-on-pay resolution won the support of just over 50 percent of Verizon shareholders.

Now, Wall Streeters ranging from institutional investors such as TIAACREF, which handles many teachers’ pension funds, to Moody’s and other credit-rating agencies also are frowning on outsized pay packages. “Main Street had almost accepted that CEOs are ridiculously paid compared with the average person, but when institutional investors start to get involved, Corporate America listens,” said Bill Coleman, senior vice president of Waltham, Mass.-based Salary.com.

The Performance Dictum

All of this is having an impact on board compensation committees. The severance agreements that helped some infamous failed CEOs land comfortably were the first casualty.

“We moved from corporate severance being a bridge for a CEO to find a new position to being an egregious wealth-accumulation tool,” says Ed Savage, co-founder of Stanton Chase International, a Los Angeles-based ex – ecutive-search firm. “That kind of selfaggrandizement is being much more closely scrutinized by shareholders.”

You Want Pay for Performance?

Big-company CEOs are getting more heat over their compensation these days. But Mercer’s latest comprehensive survey of 350 large corporation CEOs shows that they have been delivering much bigger percentage increases in corporate profits over the last five years than corresponding percentage increases in their annual compensation.

Remarkably during this time of criticism, big-company CEOs haven’t increased their salaries as a proportion of their overall compensation. Pay-for-performance advocates, however, criticize the steady and significant decline in the proportion of compensation that is directly tied to long-term incentives, and they would like to reverse it.

The pressure has led to a new determination by boards and shareholders to tie pay religiously-and much more obviously-to performance. Even President Bush, a former CEO, has made the suggestion. So CEO pay now tracks big companies’ three-year performance pretty closely, reports a new Watson Wyatt study.

Boards are further tightening the bond: More of them are rewarding only achievement of performance goals-using instruments such as longterm incentives tied to strategic objectives- in place of granting stock options that allow CEOs to cash out in a good market even if their performance hasn’t merited it.

But critics are not appeased. “We think there still needs to be accountability in pay for performance, real performance, not the quasi-notion of performance,” says Amy Borrus, deputy director of the Council of Institutional Investors, an activist group in Washington, D.C.

Ultimately, Borrus’s quest is likely to prove quixotic for at least two reasons. First is the progress that boards have been making in relashing CEO pay to performance. Second, marketplace forces will continue to create a huge updraft under the compensation of large-company CEOs in America.

Take the case of Whole Foods Markets in Austin, Tex. The retailer adopted a compensation cap of eight times the company’s average pay for top executives in the 1980s. But its board had to push the ratio to 14 times the average pay in the ’90s as the company went public. Then, citing poaching attempts aimed at top executives, CEO John Mackey led efforts to raise the cap to 19 times the average pay in 2006.

“Unlike what all the critics say, and really unlike the rest of the world, there is a very robust labor market for top executives in the U.S. because they have so many employment alternatives,” explains Watson Wyatt’s Ira Kay, who argues that a number of factors make America’s CEO marketplace more dynamic than those in other parts of the world. The U.K. and Canada, for example, “have more concentrated shareholders and many fewer employment opportunities,” he said.

At the same time, the growing globalization of the talent search increases demand for proven CEOs from the U.S. more than it increases the supply of foreign-born chiefs who are good fits for U.S. companies, says Dennis Zeleny, the former executive vice president of Caremark who has headed worldwide HR for DuPont and Honeywell. 

Shorter CEO tenure is another inflationary pressure on CEO compensation. Because the risk of an early exit is higher than it was a decade ago, CEO candidates “ask for a bigger reward in return,” explains Scott Olsen, principal of HR services for PwC Consulting.

But an even more important validation of CEO compensation levels is the strong and growing demand for their talent from private-equity firms. “Why should CEOs go through all the scrutiny and pain and being pilloried in public?” asks Walt Shill, managing director of strategy for Accenture. “Private-equity firms understand the value that CEOs can bring and are willing to give them more skin in the game.”

In response, “public companies will be bidding up more to compensate for that perceived cost,” asserts Marc Hodak, managing director of consulting firm Hodak Value Advisors. “One way or another, we’re going to be paying CEOs the full costs for their talent.”

The relatively quick success of many private-equity firms already has dragged the issue of their CEO compensation into the public arena. Blackstone Group CEO Stephen Schwarz man, for example, is pilloried for the fact that he personally holds $8 billion to $11 billion in asset value.

 

But defenders point out that since conceiving Blackstone in 1985 with just $400,000 in assets and two employees, Schwarzman now employs 875 people to manage $88 billion in funds and a market capitalization of more than $32 billion. Beneficiaries of the resulting gains include everyone from Blackstone-backed companies such as Trizec Properties and LaQuinta Inns to the U.S. economy itself.

Add these new dynamics to always prevalent factors at many big companies, such as poor succession plan ning and boards’ tendencies to want to hire better-than-average CEOs, and there are some powerful escalators built into CEO-compensation trends. Worthy external candidates will continue to play with a strong hand-and to demand things, including some of the same kind of insulation that has cushioned infamous re cent falls from grace.

“There’s no way that CEO candidates will feel comfortable that they know everything that’s gone on in the organization prior to taking the job,”says Brian Sullivan, CEO of executive recruiting firm CT Partners. “You will have to make some guarantee to them for a few years-or the board will have to go down the totem pole in terms of the quality of candidates.

” And that brings us back to the primary responsibility of corporate boards of directors: ensuring the prosperity of the enterprise, largely by hiring the best CEO they can find-and paying them what they’re worth. Ideologues may be able to chip away at this basic relationship, but as long as America is the biggest and best en ine of global capitalism, they won’t be able to shake it.

About dale buss

dale buss
Dale Buss is a long-time contributor to Chief Executive, Forbes, The Wall Street Journal and other top-flight business publications. He lives in Michigan.