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Pay in the Balance

Some severance packages are so rich it’s a wonder CEOs still work. Here’s how to avoid shareholder ire in compensation.

What a difference a year makes. In 1999, the outcry over CEO compensation was muted by spectacular shareholder returns. Who cared if CEOs raked it in so long as shareholders got a bonanza, too? But with the bear market out of hibernation, current CEO compensation seems out of balance with everyone else’s leaner salaries and investment portfolios.

Hence, the hue and cry over outsized option grants, sign-on bonuses, perquisites, and severance packages. The ink was drying on corporate proxies as the media rushed to print reports of CEOs with compensation packages to make Croesus blush-at a time when their companies counted pennies. Beyond the raised eyebrows, however, is some serious soul-searching by boards of directors and executive compensation committees to construct balanced and fair compensation packages that attract and retain talented chief executives and give them incentives to improve performance.

This is easier said than done, of course, because of intense competition to get the right person at the right time. “It’s a squirrel chase, with everyone running around in circles trying to pay the CEO what he or she is seemingly worth without considering what they will do,” says Judith Fischer, managing director at Executive Compensation Advisory Services in Alexandria, VA.

The current economic malaise should temper such extravagant expectations. Together, the Dow Jones and NASDAQ markets are more than 20 percent off their peaks at the end of 1999. And 2001 marks the close of a bountiful era when several factors-the shift from cash to equity in compensation, the special accounting treatment accorded nonqualified stock options, a booming stock market and economy-combined to reap unprecedented wealth for the boss. CEO pay these days is very much feast or famine, in the opinion of Carl R. Weinberg, principal at Unifi Network, a unit of PriceWaterhouseCoopers. This month Unifi issued the results of Chief Executive’s 14th annual survey on CEO compensation in a Web site exclusive feature. The survey found that the median base salary for a CEO rose by 4.5 percent from 1999 to 2000. In total performance pay, the CEO’s increase was 24.7 percent. However, Weinberg points out, 36 percent of CEOs received less total cash in 2000 than in the previous year while 35 percent received less total performance pay in that period.

The average CEO compensation package in 2000 totaled $10.9 million-up 16 percent over 1999 despite stock market downturns, according to a study by Pearl Meyer & Partners, a New York City-based executive compensation consulting firm. These packages included $6.34 million in stock, up 28 percent from the year before; an average annual bonus of $2.01 million, up 20 percent; and an average base salary of $1.13 million, up 4 percent.

Some CEOs received pay packages beyond $10.9 million. Of course, these were negotiated by the prospective CEO and his or her lawyer or agent and the board’s compensation committee. While some may consider the packages exorbitant, boards agreed to them. Citigroup’s Sanford I. Weill netted $151 million last year for the services he rendered to the New York City-based financial services giant. And John F. Welch Jr. chalked up $125 million or so as the chief at General Electric. That kind of compensation seemed worth the cost at a time when investment returns perked right along. Nowadays, institutional investors, and the proxy advisory firms that counsel them, are having second thoughts. “The equity being allocated in these pay plans is becoming a big issue at annual meetings,” says Patrick McGurn, a vice president at Institutional Shareholder Services, a Rockville, MD, proxy advisory company.

“Many boards are now saying they need to reduce the risk in CEO pay.”

Certainly the sign-on bonuses unearthed in recent proxy statements (Fischer believes hey’re worth twice the value of the average CEO salary in 2000) is giving pause. The $45 million cash sign-on bonus of Gary C. Wendt, who left GE Capital to become CEO at Conseco, the once-ailing insurance and finance company based in Carmel, IN, made the sums paid to sports stars look meager. In Wendt’s case, the bonus replaced lucrative options and other pay he forfeited at GE Capital. And Conseco, performing poorly for some time, arguably required someone of Wendt’s stature to reverse its slide. Says Fischer, “Corporations that need a CEO badly have to pay the piper.”

Such was the case at Bank One, which courted and won Jamie Dimon with a salary of $1 million, 33,000 restricted shares worth $1 million, 3.2 million options, a guaranteed $2.5 million sign-on bonus and, thereafter, a target bonus of 2.5 times base salary.

Weinberg of Unifi says: “Sure, that’s a very rich deal, but Bank One is a troubled company and Dimon is a name, a guy with a solid track record in financial services who was probably looking at a number of other opportunities. If a big sign-on bonus is what it takes, then so be it.”

But are lucrative bonuses the only carrot to lure a hungry CEO? “Whatever happened to promoting from within, spotting and training talented executives for the top spot?” says Fischer. What about those smart Japanese and European CEOs as candidates for the top spot at American companies? “There are wild bargains for CEOs from foreign countries who have run very good and large companies, yet nobody brings them in,” says Ira Kay, practice director at Watson Wyatt Co., a compensation consulting firm in Washington. And that does not take into account the mere challenge of the job.

Pearl Meyer, president of Pearl Meyer & Partners, says that some generous sign-on bonuses bespeak inferior recruiting. “Executive compensation committees have a habit of permitting recruiters to develop the one perfect candidate,” she says. “The committee then falls in love with this person, which puts them in a weak position to negotiate. The end result is an egregious pay package that includes a humongous bonus.”

Sign-on bonuses are no guarantee that a CEO will right a foundering ship. And while a sign-on bonus that replaces forfeited income from a previous employer is considered reasonable, bonuses for other achievements should be connected to long-term performance goals, many observers believe. If the individual does not succeed, says Meyer, “the company should have claw-back provisions, like the forfeiture of the excess sign-on bonus.” Easier said than done.

Sweet Severance
Sign-on bonuses represent gestures of promise and hope. Severance deals, on the other hand, can be an exercise in despair. Take the case of Roger Eigsti, the former CEO of Safeco, the Seattle-based insurer who resigned under pressure last year. Safeco is still struggling with a heavy debt and deteriorating results from its core business and homeowner insurance lines. Yet, Eigsti took home a $3.6 million severance payment, more than $300,000 for unused sick leave and vacation time, a car and golf club membership worth more than $100,000 and tax and legal advice during the severance negotiations worth some $2,500. He was forced to give up 100,000 stock options, but he kept 340,000 others.

His exit-door riches pale when compared to terms in the contract of Linda Wachner, CEO of Warnaco, the maker of intimate apparel and other clothing. In 1999, her base salaries, from Warnaco and Authentic Fitness, which Warnaco has since bought, totaled $3.785 million. These exceeded the base salary for Jack Welch at GE, which has roughly 50 times the revenue and 100 times the net income (although Welch received about $10 million in bonuses that year while Wachner got none).

As one of the few high-profile women running a big company in the early 1990s, Wachner built Warnaco from a bra company with $590 million in sales into a $2.25 billion a year business with retail brands like Calvin Klein jeans and Speedo swimsuits. But that was then. Now, the Warnaco Group, as the company is known, has virtually collapsed. In April 2001, the company announced that it lost $338 million the year before, and had little more than $11 million in cash on hand. The stock, $44.375 a share in July 1998, was at 75 cents in May and the company had almost $1.84 billion in debt.

Wachner has a contract many CEOs would envy. If the company dismisses her, it must pay her five times the highest annual salary and bonus that she has ever received. That would mean a Midas-size parachute of about $44 million. That seems to be more cash than the company has.

“The usual argument for severance is that to attract a solid CEO you must compensate them if things don’t work out, since they can’t simply return to their former employer,” says Prof. Charles Elson, director of the University of Delaware’s Center for Corporate Governance. “But what it really says is: €˜If we do well, you do well. And if we don’t do well, you still do well.’ Not only does this reward failure, it lowers the incentive for success.”

Not all severance deals are dubious. When a company is acquired, and new executives take over, generous severance is considered appropriate. The rationale is that it is not in the shareholders’ interest to have a CEO who will not consider a takeover offer that creates value for shareholders, but may lead to his or her job termination. “You don’t want a CEO asking, €˜Should I get a good price for shareholders or protect my job?'” Weinberg says. In such cases, he recommends a balanced severance that includes an acceleration of vesting for options, restricted stock and salary, and a bonus continuation-in a lump sum.

Even when there is no management change but a shift in control, Weinberg argues, severance is important. “If there is no measure of severance protection, you’re encouraging the CEO to take risks that may be greater than shareholders want. If they fail a little bit or a lot they still get nothing, so they’re tempted to take big risks in the hope of succeeding wildly.”

The problem isn’t severance, he says, “it’s crazy severance, like the Safeco deal.”

McGurn, the proxy adviser, agrees: “It’s a matter of numbers. Traditionally, the standard severance was 2.99 times the average annual compensation over five years. Recently, though, we’ve seen severances negotiated that are four to five times annual compensation, a mix of cash bonuses, long-term incentive stock option grants and so on. Given the recent poor performance of some CEOs, numbers like these now raise shareholders’ hackles.”

Some severance packages were so generous that when they became known they gave the companies black eyes. Jill Barad, who is credited with successfully marketing Barbie dolls at Mattel, blundered after putting $3.5 billion into the acquisition of The Learning Co. It became a failed enterprise. Barad’s goodbye kiss was a multimillion-dollar severance package that combined the generous (five years’ salary and bonuses worth $26.4 million) and the ludicrous (options to buy her office furniture for $1; free financial-counseling services; forgiveness of a $4.2 million personal loan; forgiveness of a $3 million home loan). She also received $3.31 million to cover the taxes she owed on the forgiveness of her home loan.

Stephen Hilbert left Conseco with such a large payout that he can easily live like the millionaire he is. Like Barad’s, most of Hilbert’s package was written into his employment contract. It called for a cash payment of about $72 million, five times his annual salary and bonuses. But the day before he was fired he got 2 million options. Ironically, Hilbert must still repay the $179 million in bank loans that his company backed. His shares won’t nearly cover his debt, but he may have a long time before he has to repay the loan. No date is specified in Securities and Exchange Commission documents for the repayment.

In between sign-on bonuses and severance deals is the heart of compensation-the pay package that will attract the best storekeepers without giving away the store. To achieve a purposeful balance, there has to be a blending of salary, stock options, restricted stock grants and perks like country club memberships and corporate jets. Unfortunately, says McGurn, “I don’t think anyone has the right balancing act figured out.”

Stock options will continue to be a mainstay of pay packages, despite criticism. CEOs are likely to continue to press for lucrative options and companies probably will continue to grant them, thanks to the accounting treatment (options don’t require a charge to earnings).

Stock options also remain solid retention and incentive devices, particularly if tied to long-term goals. Boards that grant ever larger options feel they must do so to compete against other companies.

Meyer estimates that 58 percent of CEO pay is now represented by stock options, roughly double the percentage 10 years ago. She believes that options should account for no more than 30 percent of the pay package for a CEO of a mature company, and no more than 45 percent for the CEO of a growth company. “Balance is critical in order to achieve a package that truly encourages improved performance,” she explains.

Weinberg prefers a dollar-cost averaging approach. “The mistake companies make with options is they ignore the extraordinary volatility of the stock market,” he says. “An individual company’s stock price whipsaws back and forth, which means if you’re making big option grants you’re at the mercy of the particular peak or valley on that date. If the share price plummets, you’ve given away the incentive; if it rises, you’ve overgranted. Conversely, by making a series of option grants, on a monthly basis, for example, you can dollar-cost average the exercise price.”

While options play an important role in the compensation package, Fischer believes that other performance-based pay strategies must be considered. “I’m an advocate of stock options, but I’m against them when they’re the sole performance measure a company uses, since they reflect just shareholder appreciation,” she says. “What about other aspects of long-term growth, such as earnings, cash flow and bringing product to market? Companies should set performance goals for each of these and base CEO bonuses accordingly.”

Part of the pie could be restricted stock grants, given their value in encouraging long-term performance. The better the company performs, the more the stock is worth. “You’re basically giving the full value of the shares to the CEO as compensation,” says Kay. “If the stock depreciates from $10 per share to $8 per share, the holder loses $2 in value but is still $8 per share ahead of the game. And if it rises-well, that’s obvious.”

But rather than just give restricted stock to CEOs, Kay says boards should also sell it-at a discount. “You want them to have skin in the game and this is a good way to get that,” he says. “We’ve had good success with this strategy with several clients, including MCI and GTE.”

Elson says restricted stock also imposes restraint on boards of directors to give away less stock overall. “With options, the fact you don’t have to take a charge on earnings often encourages boards to be overly generous,” he says.

Merger Maneuvering
Stock options are a hot button not just because of their ubiquity and size. The repricing of options for underwater stock is under siege, as is the practice of canceling worthless options and granting new ones-a Microsoft tactic. The software giant decided not to cancel its underwater options because of the accounting consequences and, instead, just granted new ones.

“The goal in the Microsoft case is to replace the loss of incentive caused by the collapse in stock price. But the CEO supposedly was motivated when the options were granted in the first place. That didn’t do shareholders any good then, so why should it now?” wonders Weinberg.

The practice of limiting accelerated vesting of options during a merger also is under scrutiny. The argument for the accelerated vesting is that, without it, CEOs would be less inclined to pursue a merger. “There isn’t job security after a change of control,” says Fischer. “While I don’t like to see options ever accelerated, this is one area where it makes sense to alter the terms.”

But what if the merger is approved, the stock vests and then the merger fails to go through? That happened last year to the beleaguered Sprint Corp. following its failure to obtain regulatory approval to merge with WorldCom. Fischer advocates tightening the rules so that a merger must go through for the options to vest. Kay proposes that acceleration only occur if two triggers are pulled-the company is bought and the CEO loses his or her job.

The perceived inequity between CEO pay and performance is causing shareholders to look more deeply into the pay process. Urged on by proxy advisory firms to vote against aspects of compensation packages, institutional investors like Calpers, the giant California public employee union, and TIAA-CREF, the insurance heavyweight, want greater shareholder input in approving restricted stock and stock option plans, subjecting the compensation arena to more scrutiny. “We’ve seen a pickup this year in the number of shareholder ballots concerning CEO pay,” says McGurn.

“Several institutional investors have interest in tying pay closer to a CEO’s performance. This issue is beginning to attract substantial votes.”

But Kay believes the activism is a tempest in a teapot. “Proxy services may recommend voting €˜no’ against stock option plans, but this never gets implemented because institutional investors are satisfied and not at all unhappy,” he says. “The returns have been so spectacular, even with the market downturn, that it is hard to complain.”

Rather than insert themselves into the compensation process, shareholders can lobby for stronger compensation committees. A lot of committees include people who either don’t know much about the company or about compensation issues, in the opinion of some experts. They believe that the committees are easy to influence.

One bright light: The interlocking directorate that raised eyebrows is largely gone, because of added disclosure requirements and new corporate rules. Bank of America, for example, prohibits a director who serves as an executive at another company from serving on its compensation committee if any executive officer of Bank of America serves on the other company’s comp committee.

Giving It Back
An unusual but not unprecedented development in pay is the notion of giving back compensation when the company performs poorly. This practice (common in the 1940s and 1950s) has re-established itself, with such celebrated CEOs as Carly Fiorina at Hewlett-Packard, Roger Enrico at PepsiCo and Richard Fairbank at Capital One finding it desirable to cut their salaries or give back part of their bonuses.

Cynics would argue that the altruistic gestures are nothing more than good public relations, a way to ease tensions with shareholders and boost employee morale. After all, the CEOs certainly can afford the charity. “It’s not like they’ll suffer from the loss of that compensation,” says Fischer. “But I still think it is an elegant statement.”

Certainly, more givebacks wouldn’t hurt. In the early 1990s, blistering comparisons were made between high paid American CEOs whose companies were in the doghouse and lower paid CEOs from Japan whose companies were riding high. As the U.S. business machine re-engineered itself and ignited the dormant economy in the late 1990s, those high salaries and other perks seemed justified. Now the economic and political tenor has changed again.

More responsibility and accountability in CEO compensation-by those who pay it and those who receive it-may be in order.

Goodbye KISSES

Who says losing one’s job is one of life’s nightmares? Some CEOs actually are better off fired, thanks to the generous deals they’ve worked out post-job termination. Other CEOs who have (more gracefully) retired also took home more than their credenzas. Both beg the question – why bother working? Read these lists and just imagine the fun in unemployment.

CEOs with unusually large compensation packages in their final year of employment:

Sara LeeConsultant through 2009 at $500,000 per year
First Union10 years at 120 hours per year of corporate aircraft use
Sears, Roebuck and Co.$9,060,000 additional lump sum payment
Key Corp.Additional two years of compensation and benefits
Eastman KodakContinued use of corporate aircraft
Kmart$2,827,500 consulting agreement
CEOs with severance packages so generous they might be better off terminated:
Procter & Gamble$9.5 million lump sum payment
Home Depot$20 million additional option grants, and loan forgiveness
Gillette$8.7 million, continued option vesting and pension service credit
Walt DisneyMinimum post-termination bonuses of $6 million per year
First UnionSeverance of 5 times salary plus highest earned bonus
* CEO terminated employment during 2000 Source: Carl Weinberg, Unifi Network


Everyone agrees that striking a fair balance in CEO compensation is a Solomon-like task. There is little debate, however, concerning what not to do, courtesy of some egregious examples plunging some companies into very hot water. These red flags will guarantee bad press and shareholder uproar.

The CEO who asks for a special medical fund to finance the insurance deductibles in his or her health benefit package. Boards have agreed, only to end up embarrassed when the CEO’s first act is to cut everyone else’s employee benefits.

The CEO who doesn’t like his pay package and makes an end run around the compensation committee and goes straight to the board. “Right away, you’ve got someone who is playing by his or her own rules, irrespective of the experts,” says Prof. Charles Elson, director of the Center for Corporate Governance at the University of Delaware.

The repricing of options to make them worthwhile. The idea here is that underwater stock won’t keep the CEO swimming long, so by repricing the option to lower the exercise price you’ll remotivate the CEO. Shareholders hate the practice, which is akin to changing the rules mid-game. Besides, when the CEO supposedly was motivated, how come it didn’t boost performance then?

The cancellation of down-and-apparently-out options, which are then replaced by a restricted stock grant to the CEO. Tyson Foods canceled 150,000 stock options to its CEO, John Tyson, replacing them with 45,000 restricted shares, according to Carl Weinberg, principal at the consulting firm Unifi Network. “Pretty sweetheart, but a deal that makes shareholders wonder,” he says. “It’s no different from a board setting performance targets for a CEO bonus, then relaxing them when the target is not realized.”

Continuing perks like country club memberships after booting the CEO-a la Roger Eigsti, formerly of Seattle-based insurer Safeco-is probably not a good idea. Says Weinberg, “The purpose of a club membership is so the CEO can entertain clients and other stakeholders. Giving them this perk spares him the embarrassment of being barred from the club because he’s been fired. Well, too bad.”

Sharing the Wealth: LEADERS AND LAGGARDS

Stock options aren’t the exclusive domain of the executive suite – or are they? The following charts list corporate examples of Share-the-Wealth Leaders that spread stock option grants below the Top Five Officers, and Share-the-Wealth Laggards that concentrate stock option grants among the Top Five.

About Russ Banham

Russ Banham
Russ Banham (russ@russbanham.com) is a contributing writer to Chief Executive