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Not How Much, But

Nobody likes to be evaluated. Especially if your pay outstrips your performance. In our third annual study of chief executive pay, we take CEOs to task for their high earnings: Are they worth it? Sometimes yes…

Why bother to wade through yet another indictment of CEO pay? To read the current crop of articles on the subject, you are either led to believe that chief executives spend all their time figuring out how to bilk shareholders, or you are dragged through a morass of “data” only to be told that pay is not correlated with anything.

We have found a better way to align your interest as CEO with shareholders’, minimize distractions to your board, forge together your management team, and (incidentally) share in the wealth created for others. We even developed a simple test you and your team can apply to your own pay packages, in order to gauge their effectiveness in this pursuit.

How could we succeed while so many others are on the same scent? First, our methodology for valuing CEO pay-as opposed to that used in all the general business magazines-provides an uncluttered view of what is being delivered in any particular year. And second, rather than searching for a performance measure which somehow correlates with pay (relevant or not), we took the opposite tack-identifying an aspect of CEO pay which is present in successful companies but lacking from less successful ones. Our conclusion? There are two key ways to develop an effective pay plan for CEOs. First, make certain that pay is aligned with performance; that is, high performance needs to yield high pay; conversely, low performance should hurt the CEO, just as it does the shareholder. Second, design a plan which ensures that sufficient leverage is built into pay opportunities.

The good news in this third annual study of CEO pay is that progress is being made toward aligning pay with performance; the bad news is that the ball is being dropped on the leverage side.


The rest of the business press is finally reporting what was established in a survey we conducted last year: CEOs and board members believe that the weakest aspect of CEO pay plans is the lack of a longer-term focus. Two-thirds of the respondents to our survey felt that long-term incentives should be emphasized, and that most CEO pay plans could benefit from greater leverage-both up and down. But our findings suggest that although their sentiments are in the right place, little progress is being made to correct the lack of leverage.

It’s encouraging that pay and performance are aligned. In fact, 67 percent of our 225-company sample did align pay with performance this year (i.e., those companies that deliver high pay got high performance, whereas those with low performance delivered low pay). This is a slight increase over last year’s 65 percent of companies aligned, and the 64 percent that aligned pay with performance the year before.

The good news continues as shareholders’ return has increased substantially, averaging 15.7 percent over the 1984-1988 performance period. Last year, the annual return to shareholders from market price appreciation and dividends averaged only 11.4 percent, down from the previous year’s 17.5 percent average.


Yet while performance is recovering from a slump, the increases in CEO pay are relatively modest. In the face of higher shareholder returns, total performance pay (which consists of base salary, annual bonus, plus the annualized present value of long-term incentives) increased by only 5.2 percent. What caused this slowdown in CEO pay increases? (The slowdown is more dramatic in view of last year’s 8.1 percent increase despite plummeting shareholder returns.) Although salaries increased by 8.8 percent and total cash (salary plus bonus) went up by 13.7 percent, the amounts provided by long-term incentives remained virtually the same. Moreover, the types of long-term incentives used have shifted away from “pure” market-based incentives (such as stock options), toward less market-sensitive vehicles such as restricted stock grants, performance shares, and performance unit plans. When performance is up, these “less market sensitive” places deliver relatively less pay.

In last year’s survey, we developed a method of quantifying the rewards and penalties CEOs received relative to the value they created for shareholders. Comparing pay premiums or penalties with performance premiums or penalties (see box, “Methodology and Terms”), this year’s average pay premium per $100 in performance premium is only $0.50-down from an average of $1.06 last year. Consistent with last year’s findings, the $0.19 average pay penalty per $100 in performance shortfall is substantially less than the premium. This tells CEOs that there continues to be less downside risk than upside potential, but even the magnitude of upside potential is being cut back.

So while pay is becoming aligned, the degree of leverage afforded CEOs is decreasing. What is particularly disturbing about this trend is that alignment of pay, in and of itself, means relatively little. We could find no evidence that companies that have aligned pay with performance are more likely to provide shareholders with greater value.

In the past, we’ve said that in the case of high paid/low performing CEOs, the board would (presumably) be forced to take action. But after three years of compiling data, we may have overestimated the willingness (or ability) of boards to take decisive action. Of the 42 companies that changed their CEO, we only found evidence in five instances that the departure was anything other than normal retirement. Although no chief executives from our sample left for other, better-paying positions, we predict that the lure of LBO opportunities will entice the best to trade in their $0.50 per $100 premiums for the $5 per $100 available to those willing to take a calculated risk. 


So what is our advice to CEOs? Be certain that pay and performance are aligned and that your pay program contains enough leverage. To determine how much leverage is enough, we direct you to Exhibit 1, the leverage index chart. We constructed this index by determining how much pay would be delivered if the company’s share value increased by 15 percent per year. We then calculated the amount of pay which would result given no growth in market value. Dividing the 15 percent scenario by the zero growth mode, then subtracting one, yields the leverage index. As the chart implies, those companies with more leverage have provided the greatest returns to shareholders.

How should leverage be enhanced? The accounting, cash flow and tax advantages afforded by stock options still make them the best bet in our eyes. Variations on this theme, such as leveraged stock options or the offset-carry plan (see “The Absolute Best Takeover Defense,” May/June 1989), may be adapted for virtually any organization. But the basic theme remains the same: It is not the absolute amount of pay which best predicts company performance; rather, it is the degree of faith CEOs have in their cornpany (as evidenced by how much pay they are willing to risk) which tracks shareholder return. Who knows? If any financial analysts read this, they may start digging through proxies to identify those whose pay plans establish them as true entrepreneurs-those who assume the risk of success.

David R. Meredith is chairman and cofounder of Personnel Corporation of America (PCA), a New York-based consulting firm specializing in human resource management. A former principal of McKinsey and chairman of Meredith Associates, Inc., he holds a Ph.D. from M.I.T.’s Sloan School of Management and a B.A. from Colgate University.

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