At leading companies, compensation committees make changes to heed criticism of egregious pay. Washington likely will spur others.
September 1 2002 by Russ Banham
Last year one could taste the vitriol as corporate proxy statements unveiled an indecent imbalance between company stock performance and CEO pay. While shareholders’ portfolios plummeted, many CEOs raked in more cash than some countries’ GDP. Cries of “off with their heads” were voiced in living rooms and office corridors.
Did all the huffing and puffing fall on deaf ears? Apparently not. According to surveys by several executive compensation consultants, boards took the criticism to heart. In a year marked by economic turmoil, terrorist attacks and corporate scandals, CEO pay isn’t what it used to be. While the surveys differ on the degree of the pay cuts they found, they generally paint the same picture: With corporate profits down, so is compensation.
The changes aren’t revolutionary, by and large, but base salaries have fallen. So have bonuses and options. Some surveys also indicate that stock option grants are down, “a consequence of all the criticism and the continuing dour economy,” says Judith Fischer, managing director at Executive Compensation Advisory Services, an Alexandria, Va.-based consulting firm.
What’s more, growing evidence suggests that compensation committees are seriously weighing governance issues, drafting more detailed analyses of strategy and clarifying what they consider best practices.
A snapshot of overall CEO compensation must take into account just how many companies participated in the surveys. Pearl Meyer & Partners analyzed the proxies of 200 large U.S. companies, and found that one in five of the CEOs took no bonuses last year. Mercer Human Resource Consulting studied 350 proxies and learned that average annual CEO cash compensation (base salary plus annual bonus) fell 2.8 percent, to $1.6 million, in 2001. It was the first decline in pay in the 10 consecutive years that the New York consulting firm has conducted the survey. More than a quarter of CEOs received no base salary increase and more than half received a lower bonus or no bonus at all. The latter seems to be tied to corporate performance: Net income for corporations declined a median 18 percent in 2001, while annual CEO bonuses declined a median 14 percent.
These same relationships held true at all levels of corporate performance. Companies in the 75th percentile saw their profits rise 15 percent, with a corresponding increase in CEO bonuses of 18 percent. Meanwhile, companies in the 25th percentile saw their profits drop by 69 percent, coupled with a corresponding drop in CEO bonuses of 58 percent. “The survey convincingly demonstrates the closest relationship yet between CEO pay and performance,” asserts Peter Chingos, head of Mercer’s executive compensation practice.
Watson Wyatt Worldwide, a consulting firm in Washington, looked at pay practices of 1,000 large U.S. companies. Although not completed at press time, preliminary results add to the chorus. In half of the 500 companies it had studied so far, the top executive took a substantial pay cut in 2001.
That’s not to say that instances of eyeball-popping compensation packages are gone. The jaw still drops at the $175 million that CEO Thomas Siebel of Siebel Systems hauled in last year. All but $1 (his 2001 salary) came from option profits. Ditto former Qwest Communications CEO Joseph Nacchio’s bounty of $102 million-of which almost three quarters was from stock options.
Another sore spot, at least in Mercer’s survey, surrounds the long-term equity portion of CEO pay packages. While many companies in the survey gave no bonus to their CEO in 2001, several made up for it with larger stock option grants. Charles Schwab, CEO of the eponymous firm, for instance, took a 93 percent pay cut in salary and bonus in 2001, but was given 1.1 million options-nearly four times the number he received in 2000. He wasn’t the only CEO to receive a larger share of options than in previous years. Three out of 10 CEOs surveyed by Mercer also received an option mega-grant with a face value of at least eight times the CEO’s total annual compensation. However, many such equity awards came with restrictions, such as longer vesting periods or performance features, to ensure long-term CEO focus and to maintain the link between pay and performance.
Committees crack down
Chalk up the changes to compensation committees. For the most part they’re comprised of independent directors, who are meeting more often and scrutinizing their structures and charters. Some are even drafting new formal statements outlining the company’s performance culture. “Obviously, outside directors have a stronger hand on compensation,” says Robert Stobaugh, a professor emeritus at Harvard Business School who in the past has sat on several compensation committees, among them Ashland and National Convenience Stores.
Boards are establishing salaries as a median against the marketplace with competitive bonuses that rise or fall depending on financial performance. Long-term incentives and capital accumulation are heavily leveraged and tied to the creation of shareholder value. And when CEOs meet technical goals for a bonus, but the company’s financials are suffering, adjustments need to be made, urges Ira Kay, Watson Wyatt’s executive compensation director. He observes that discrepancies occur when companies tie bonuses to metrics-such as economic value added, or EVA, a popular corporate performance gauge that measures net operating profit minus a charge for the opportunity cost of invested capital-that are not strictly driven by earnings. “I’ve seen companies that didn’t meet their earnings-per-share goals and their stock price went down, yet the board still had to grant a bonus to the CEO because the EVA warranted it,” he points out.
One company that serves as a model for compensating the chief is Nucor, a steel producer in Charlotte, N.C., with $4.1 billion in 2001 revenues. The Corporate Library, an outspoken critic of high CEO pay, calls Nucor the top company in America for executive compensation. At Nucor, company performance indicators are riveted to every employee’s bonus, from entry-level clerks to the CEO. “It’s one of the main reasons we are now the country’s largest steel producer,” boasts Dan DiMicco, Nucor’s CEO, president and vice chairman.
DiMicco has worked at Nucor for 20 years, rising through the ranks to assume the CEO post in 2000. “I’ve always been a big believer that the level of your pay should be tied to your employer’s performance,” DiMicco says. “When I read about some CEO making $50 million as the company’s stock value is plunging and shareholders are losing money, it gets me steamed. You make a company win by financially motivating employees to perform at their best.”
That’s what Nucor has done since the mid-1960s. All employees have the opportunity to achieve higher compensation by meeting or surpassing financial metrics particular to their jobs. For example, a steel production employee’s incentive bonus (representing two-thirds of base salary) is tied to the production of quality steel. If X tons of steel are produced in a given time meeting customer specifications, bonuses are awarded.
Bonuses for clerical workers (up to 30 percent of base pay) and for department managers (up to 90 percent) are tied to return on assets. Senior officers, including the CEO, have their bonuses (up to four times their base pay) hinged to return-on-shareholder equity. DiMicco’s base salary is $423,000. Last year, the senior officers came a cropper. “All we got was base pay-we didn’t reach profitability levels to award a bonus,” DiMicco says. “Most everybody else-crews out in the field, division heads, etcetera-got their bonuses.”
The bonus comes in two forms, cash and restricted stock. The stock (one-third of the bonus) is placed in a forfeitable account to assure long-term commitment; it vests 100 percent in five years. “In my case, if I leave the company before age 55, I’d lose the stock,” says DiMicco, now 52.
Paul Hodgson, a senior research associate at The Corporate Library, says that Nucor, “despite offering very moderate stock-option grants, base salaries and severance packages, still outperforms its peers and has no difficulty recruiting or retaining executives.”
He also commended another aspect of DiMicco’s pay: The phasing in of stock-option awards reduces the possibility of freak outcomes due to stock price volatility. Each year of DiMicco’s tenure as CEO he’s received two small awards of stock options at six-month intervals. The awards were worth $328,094 and $764,600 at 5 percent and 10 percent annual stock price appreciation, respectively-well below the value of comparably sized companies. “Although there are no performance conditions to these stock options, the moderate nature of the awards mitigates this,” says Hodgson.
Stock option stunts
Indeed, managing stock options remains one of the trickiest tasks facing board compensation committees, and the task is bound to generate more controversy. Several factors must be taken into account, such as the fair market value of the stock on the grant date and the value the stock represents as a percentage of overall salary. Moreover, warn pay experts, companies luring top drawer talent with big stock options should tie them to some measurable performance variable such as a successful product launch or the number of products in the pipeline.
Ian Singer, assistant vice president and executive compensation consultant at Aon Consulting in New York, warns against giving options at strike prices that are much lower than actual share prices. “You want to give the CEO an incentive-based advantage, but not too much,” he says. “On the other hand, if you don’t price the option lower you may wind up having to reprice the option at a later date if the stock is underwater. That creates dilution and perceived unfairness by shareholders who, of course, can’t reprice their shares.” Singer’s advice: Reduce option grants in favor of restricted stock, which doesn’t produce geometric returns and makes executives accountable when the share price falls. Other compensation experts suggest restricted stock in a bonus be unavailable for two years after a CEO’s departure, which helps keep the focus on long-term goals.
Certainly, linking CEO pay to performance is a powerful inducement to do one’s best. Nuevo Energy takes this concept to the extreme, paying its CEO entirely in restricted stock. Jim Payne, chairman, CEO and president of the Houston-based oil exploration company, with $371 million in 2001 revenues, receives no base salary and his annual compensation-$400,000 in stock-is geared entirely to corporate performance. If Nuevo achieves certain financial metrics, Payne also receives a bonus of between $200,000 and $400,000 in additional restricted stock.
Given that stock prices for the 12-year-old company had fallen from $55 a share a few years ago to a low of $10 a share before Payne came on board in 2001, the compensation scheme is risky. Yet Payne says, “It’s a great opportunity for me to put my money where my mouth is.”
Nuevo had fallen on hard times in 1999 and 2000 due to the untimely sale of various gas assets, some fruitless exploration activities and a disastrous hedging program that cost it $200 million, pre-tax, in 2000. Payne, who previously headed Santa Fe Energy Resources, convinced Nuevo’s board he had a plan to turn the company’s fortunes around. “To convince them, I offered to make my pay entirely dependent on stock performance-if I failed my shares would fall in value,” he explains. It was too good an offer to refuse.
As CEO, Payne brought along several senior executives from Santa Fe (since acquired by Devon Energy) to help him restore the company. So far they’ve taken some $40 million out of Nuevo’s cost structure. The stock price is reacting, up some 50 percent to $15 a share since Payne took charge.
The new CEO also revamped senior management’s compensation strategy, linking bonuses to specific performance indicators. Previously, bonuses were hinged to EVA, which Payne felt didn’t align the interest of shareholders with the company. Incentive-based bonuses also are in place for non-senior management, based on the same criteria. Payne has the opportunity to double his base pay, senior managers can achieve 75 percent of base pay and clerical workers 5 percent.
Charles Elson, director of the Center for Corporate Governance at the University of Delaware in Newark, sits on Nuevo’s compensation committee and says the pay strategy is just what Nuevo needs to rebuild. “Jim wanted to link his actions to the fortunes of the company, which tells you something about his confidence,” Elson says. “If the company does well, he does better financially. If not, his income suffers. It is the ultimate pay-for-performance concept.”
CEOs weren’t always paid like pro athletes
Once upon a time, CEOs weren’t the celebrities they are today. They were industrious folk who typically ascended the ladder by dint of perspiration and perseverance. Once there, they were paid well, but not the teeth-gnashing bounties many now take for granted.
But that was the ’70s, a time of recession, oil supply crises, double-digit inflation and soaring unemployment. A CEO raking in more than $500,000 a year in the “me” decade was a rarity, as remote as baseball stars making that kind of cash. Today, when Alex Rodriguez takes home $25 million-plus a year from the Texas Rangers, who can blame Siebel Systems for paying its CEO, Tom Siebel, nearly $175 million?
Over the past 25 years, compensation has become a subject of public scrutiny and, frankly, enjoyment. With the market reeling, it’s plain fun to take potshots at overfed execs.
But this wasn’t always the case. Robert Stobaugh, a professor emeritus at Harvard Business School, remembers when CEOs were just regular guys commuting to the office in off-the-rack suits. “CEOs 25 years ago never got a million dollars; their compensation was based on common sense,” says Stobaugh. Back then, he says, CEOs were seen as diligent managers who had skill motivating people and “just got promoted up through the ranks.”
The first real change came in 1986, after a landmark ruling in Smith v. Van Gorkom. The judge essentially ruled that the board had failed in its governance by not using an outside consultant to advise them on management issues. “The lawsuit encouraged boards to hire consultants for different things, one of which was executive compensation,” Stobaugh recalls. Once the consultants got involved, an “upward bias” in CEO salaries ensued, he adds. “Directors would insist that the CEO be in the upper 25 percent of income for that particular industry,” says Stobaugh, who has sat on several boards, including Ashland Oil’s.
Suddenly, it was no longer uncommon for CEOs to get a million dollars and much, much more. Stobaugh says the next factor boosting salaries was 1990s legislation requiring companies to hire compensation committees comprised of individuals outside their employ. “Congress was concerned over the bonuses paid CEOs and wanted some objective performance measure tied to them-like return on investment or the stock price,” he says. Add to that a 1992 rule that required public disclosure of CEO pay, and you have a formula for competitive pay hikes.
When stock values began growing in the late ’90s, CEO bonuses followed suit. “It was hard for outside directors to ask hard questions of CEOs when stock values were flying high,” Stobaugh notes. “If management is creating 40 percent returns for investors-say $10 billion in stockholder equity-who cared if the CEO got $50 million?” The fact that the bulk of investors were institutional contributed to the seeming complacency. “With investments soaring, they just simply voted a proxy for management,” he adds.
But changes are afoot. Now that investments are not worth mentioning, Stobaugh says, institutional investors are starting to demand that companies tie CEO pay to performance. Congress, too, is jumping into the act. In July the Senate okayed President Bush’s proposal to stop companies from making loans to execs. It’s bound to become law, and more regulatory changes from Washington are expected to follow. Companies are also taking new measures. General Electric, following the lead of Coca-Cola, Amazon.com and others, announced it would account for stock options as an expense, and therefore deduct them from earnings. Some of the compensation madness seems to be waning.