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What To Do About CEO Pay?

The headlines keep coming and so does the indignation. CEO pay practices have become lightning rods for media and shareholder …

The headlines keep coming and so does the indignation. CEO pay practices have become lightning rods for media and shareholder scrutiny and are likely to become more so as the current proxy season gathers force.

In 2005, the average large company CEO pay was $10.5 million. In addition, CEO pay is becoming a larger multiple of the pay of front-line employees. CEO pay was 36 times what an average worker earned in 1976, 131 times in 1993 and has mushroomed to 369 times as much by 2005, according to Joann Lublin and Scott Thurm reporting in The Wall Street Journal.

The question is this a problem and what should be done about it?

 Institutional Shareholder Services, the Rockville, MD proxy services and advisory firm, reports that three proposals calling for shareholder “Say on Pay” have garnered an average of 42 percent in support this early in the 2007 proxy season. Seven such proposals gathered an average of 40 percent shareholder support this time last year. The best showing was a proposal put to Sun Microsystems shareholders 44.1 percent of whom approved.

The “Say on Pay” proposal by American Federation of State, County, and Municipal Employees (AFSCME) received 47 percent of the votes cast at Bank of New York. The same proposal put by them put before Morgan Stanley got 37 percent of the vote. A similar AFL-CIO proposal won just 4.3 percent of the vote at United Technologies.  In the coming days and weeks similar proposals will be voted on at annual meetings at U.S. Bancorp, Wachovia, Citigroup, Wells Fargo, Wyeth Labs, Lockheed Martin, Capital One, Valero Energy, Abbott Labs, Merrill Lynch,  and AT&T with some 50 others pending.

 These proposals would be advisory but the implication is clear. CEO pay is said to be egregiously over the top and they only way to restrain it is to submit the company and the board to a public whipping. Even the President Bush has come out to criticize CEO pay. Representative Barney Frank has led the charge with a bill that has come out of the House Financial Services Committee that would give more clout to shareholders in validating pay packages. It would also allow shareholders to vote on golden parachutes if a company is sold.

Severance arrangements or what some refer to as “pay for failure” are at the heart of the anger fueling this movement. Shareholders of home improvement retailer Home Depot voiced their discontent after outgoing CEO Bob Nardelli received a $210 million severance package. (It all started years earlier when Disney’s Michael Ovitz received $140 million after 14 months as the company’s president.) But strictly speaking the severance component of Nardelli’s exit package was small change. He received $20 million in cash and $32 million retirement benefits and the rest in bonuses, unvested deferred stock awards, unvested options, deferred share awards and “other entitlements” worth millions-all for just six years of service. 

Supporters point to shareholder practices in the UK, Sweden and Australia as having a salutary effect on CEO pay. In 2003, for example, Glaxo SmithKline chief Jean-Pierre Garnier took much public grief when his $40 retirement pay package-a pittance by U.S. standards was put to a shareholder vote. Protestors posted activists dressed up in cat costumes slurping cream in front of GSK’s London headquarters with banners calling attention to “fat cats” at the company. It was Garnier’s bad fortune that the UK, a year earlier, had mandated that all companies put CEO pay packages to a non-binding vote. An unprecedented majority, although a slim one– 50.7 percent–voted against his remuneration plan. In response the company scaled back the severance award from two years to one.

Last month supplemental life and health insurer Aflac became the first U.S. company to voluntarily participate in giving shareholders a nonbinding vote on executive compensation. AT&T is said to follow with a similar practice after the SEC turned down a request to keep such a proposal off its proxy statement.

Opponents note that the SEC recently has already issued rules requiring greater disclosure of executive pay, and that some companies already have voluntarily adopted “say on pay”-style rules. Business Roundtable president John J. Castellani, whose group represents large U.S. companies, thinks the “say on pay” legislation could encroach on board responsibilities.

Looking ahead, critics of such proposals say that forces are already at work that will curb excesses and improve severance arrangements. Boards have gotten the message and are seeing the big picture. Until recently many boards only saw individual components of executive compensation without being able to fit all the jigsaw pieces together. The practice of using compensation tally sheets where a comprehensive view is available to all directors, has caught on. In addition, more boards are insisting on better succession planning as a partial antidote to egregious pay. Having one or more candidates properly cultivated and ready to assume the tiller puts the board in a stronger position vis a vis the CEO which technically serves at its pleasure.

In its January/February 2007 issue, Chief Executive reported that CEO tenure is hovering just over five years which makes succession planning all the more important. The good news is that boards are making succession planning more of a priority.  According to ISS’ Corporate governance quotient analytics about 28 percent of the 5,000 public companies it tracks have board-approved CEO succession plans in place.

Concerns about CEO pay have become social issues as well. Large pay imbalances that separate the CEO and the people who work for him are said to cause ill will throughout the organization, according to Charles O’Reilly, director of the Stanford Business School‘s Center for Leadership Development and Research. In a recent paper researched with James Wade of Rutgers University and Tim Pollock of Pennsylvania State University, the team of academics examined how chief executive salaries affect employees. The study found that inequity in CEO pay triggers increased turnover among managers below the chief executive.

Using data from 120 large public companies over a five-year period, O’Reilly tracked five levels of senior managers from vice president to division general manager. He found, for example, that in one firm in which the CEO was “overpaid” by 50 percent compared to the industry norm and the general managers were underpaid by 50 percent, turnover among the general managers was 18 percent higher than at firms whose CEOs were equitably paid. The turnover of such seasoned managers, argues O’Reilly, has a corporate cost because it robs the firm of valuable internal experience that new employees will take years to develop. Such imbalances he argues also cascades down through senior management. He found that if the CEO was “overpaid,” the executives under him tended to be overpaid, too-magnifying the cost to shareholders.

However, another Stanford professor, Jeffrey Pfeffer, argues in his recently published book, “What Were They Thinking? Unconventional Wisdom About Management,” that all the efforts “to do something” about CEO pay may actually be counter productive. “Having participated on the compensation committees of both private and public company boards, and having read the relatively large empirical literature on executive pay, I am struck by how disconnected from any sort of reality both the commentary and the suggestions for reform are.”

The problem, he says, is that there is no evidence that reforms will work. It’s not that they are bad ideas; he contends that they just don’t accomplish what their supporters intend.  A number of years ago the tax rules were amended to make pay over $1 million not deductible unless that pay was tied to performance. Well we all know how well that worked out. In 1993, shareholder activist Ralph Whitworth closed down the advocacy group United Shareholders of America because with SEC-mandated disclosure, he thought problems with executive pay were largely over.

Did later disclosure rules revealing the disproportional percentage of stock options obtained by the CEO cause a more equal distribution of option grants? “I don’t think so,” Pfeffer argues. “If anything, all this public attention to the various components of pay may have set off an arms race, as executives were interested in not being worse off than their peers and the compensation of peers was ever more visible in the published disclosures.”

If the Lake Wobegon Effect, the tendency for people to believe that they are better than average, is not bad enough, boards and compensation committees also do not wish to believe that their CEO is below average.

“It is far from clear that pay in public companies is actually too high, given prevailing beliefs about the importance of CEOs to company success,” he maintains. If anything, CEOs may not be as crucial as conventional wisdom holds. It is the belief that the CEO is the factor that will make or break a company, that is forcing pay to ever-higher levels. Pfeffer points to private equity firms that are controlled by activist owners, actually pay CEOs of successful enterprises more than what they would earn at public companies. This suggests “CEO pay may not actually be too high.”

The “problem” with CEO pay, he argues, may not be much of a problem at all. But if executive pay is to be fundamentally changed he suggests two necessary fundamental changes. “First, probably less disclosure, not more is desirable. With secret pay and prohibitions on discussions of comparative pay, the social comparison dynamic is short-circuited.” Second, we must overcome the fundamental attribution error-the tendency to over attribute causality to certain individuals as compared to organizations and the situations in which they find themselves. In other words, junk the CEO-as-celebrity culture and CEO pay will level off to socially acceptable levels. 

If you would like to speak out, please eMail me at: jpdonlon@chiefexecutive.net

About JP Donlon

JP Donlon
JP Donlon is the Editor-in-Chief of Chief Executive magazine.