Every spring day, another proxy statement appears in the mailbox-and another newspaper headline attacks CEO pay. The criticisms are familiar: “CEO pay is unrelated to company performance.” “No one is worth that much money.” And the most emotional of all: “The pay gap between CEOs and average employees is destroying our social fabric.”
The facts say just the opposite. Most companies are strengthening the ties between CEO pay and company performance. Good chief executives are well worth the money they earn, given their limited supply and the enormous value they create. And the pay differential between CEOs and average employees is usually about 10:1, not 100:1, as some critics (and politicians) claim.
But while most companies do not overpay their CEOs, they do underpay outstanding nonexecutive employees. These high-achieving workers are lucky to earn even 10 percent more than the average. Just as foolish, too many companies organize work in teams, but base compensation on individual contributions.
The solution is to design reward systems that deliver outstanding pay for outstanding individual and team performance. To do this, companies must:
- Define the difference between “outstanding” and “adequate,” from both pay and performance perspectives.
- Identify the high-performing teams and their major contributors.
- Create superior reward opportunities that inspire employees to invest the extra effort and commitment that outstanding performance requires.
THE NEW EMPLOYMENT DEAL
The traditional employment deal doesn’t work anymore, since it neither fits today’s economic imperative to reduce costs, the performance imperative to exceed customer expectations, nor the organizational imperative to work in teams. Most important, it fails to encourage outstanding performance, because its traditional motivator-the opportunity for promotion-rarely exists.
Forward-thinking companies are implementing a new contract with their employees, one that will fit the demands of the next century. The employment contract for the new century accomplishes three critical objectives: First, it lures highly talented, self-confident, team-oriented employees who are comfortable with risk. Second, it reinforces a culture of performance by delivering significant rewards to those employees who make outstanding contributions. Third, it inspires team-oriented behavior, because employees are paid like business partners.
The new employment contract has four basic components:
- Base salaries are modest, relative to competitive practice, and do not receive automatic annual adjustments. Rather, salaries are adjusted every few years in response to marketplace changes.
- All employees are eligible for significant bonuses, based on their ability to bear economic risk. Bonuses for outstanding performance are much greater than those for adequate performance-sometimes two to three times as great.
- Most, if not all, employees are eligible for equity-based pay vehicles, such as stock options and performance-based restricted stock. This provides employees with a common purpose, encourages teamwork, and links compensation with the company’s ability to pay.
- Retirement programs shift from defined benefit (a traditional pension) to defined contribution plans, such as a 401(k). Employer costs are, therefore, more predictable, and benefits are more portable.
VALUJET AND GAYLORD: A SNAPSHOT
Many companies have begun implementing variations of this new employment contract with their employees. For example:
ValuJet Inc..- Less than three years old, Atlanta-based ValuJet Airlines, a wholly owned subsidiary of ValuJet Inc., is the nation’s most profitable airline. While others in the industry have struggled, ValuJet’s share price has increased more than 400 percent from its initial public offering in June 1994.
Most press accounts have focused on the company’s unique operations. These accounts, however, have ignored an interesting wrinkle to how ValuJet pays its employees. Salaries at ValuJet, from the CEO down, are set at the lower end of the market range, and are adjusted only when market rates change significantly. While fixed pay is low, bonus opportunities are extremely high, putting total pay opportunities above the middle of the competitive range. In addition, all employees received stock at the time of the IPO, resulting in broad participation in the stock’s appreciation.
While ValuJet’s employment philosophy has stayed the same, its implementation has evolved as the company has matured. During the start-up phase, cash reserves required constant attention to ensure that the company could secure new planes, routes, and customers. Management established cash reserves to pay discretionary bonuses based on profitability, the company’s performance, and individual performance. Now that ValuJet has become more securely capitalized, it is migrating to a formula-based bonus pool, although that pool remains payable at the discretion of the board of directors. This approach makes employees’ total compensation levels more predictable, while continuing to link pay to performance.
Gaylord Entertainment: Headquartered in Nashville, TN, Gaylord Entertainment is a leading hospitality and entertainment company. Its core businesses include the Grand Ole Opry, Opryland Hotel, Opryland theme park, and cable networks TNN and CMT.
Gaylord relies on individuals who demonstrate creativity, teamwork, and sensitivity to customers, whether they are television producers, amusement-park concessionaires, or hotel desk clerks. To help attract and retain such employees, the company made three important changes in its compensation programs. First, it moved to a market-based salary program (instead of an internally focused one), thus enabling it to compete for the best talent available. The company tailors its market pay research to the appropriate labor market; for example, local for desk managers, national for television graphics technicians, and so forth. Second, it increased bonus opportunities for employees below the executive level, so that it pays above market for meeting the company’s high performance expectations. Third, it made all professional-level employees eligible for annual grants of performance-based restricted stock.
It took some forethought to introduce these changes to employees, who were accustomed to more traditional methods of compensation. First, the corporate director of human resources outlined the changes in group meetings with all affected employees. Each worker received a customized template that calculated his or her bonus at different performance levels. Ongoing communication materials have tracked performance versus plan and stock price. As a result, Gaylord has been able to retain key personnel, improve company performance, and boost employee morale.
Too many boards are getting distracted by the phony issue of overpaid CEOs. While occasional examples of abuse still exist, the overalJ pattern is clear: The pay packages of CEOs and their management teams are more sensitive to performance than ever before. It’s time to start applying the same principles to compensation arrangements for all other employees. In doing so, companies will generate levels of commitment, creativity, and collaboration in their employees that wiJl enable them to meet the competitive challenges of the new century.
THE CEO PAY MULTIPLE: LET’S GET REAL
Year after year, critics of CEO compensation trot out the same formula-the CEO pay multiple-to calculate just how outrageous CEO pay has become. The calculation seems straightforward enough: the CEO’s total compensation divided by the average employee’s total compensation package. Most critics cite pay multiples of 100:1 or 200:1 as proof that CEO pay is way out of line. In reality, most CEOs have pay multiples of 15:1 or less.
Why the disparity between myth and reality? First, the critics assume that most people work for large corporations. Second, their calculations exclude non-cash remuneration. Third, the critics do not factor in that most CEOs work longer hours than other employees.
To arrive at high multiples of 100:1 or 200:1 (or higher), CEO pay critics only consider CEO pay at the country’s biggest companies. But most people don’t work there. For example, the 776 companies on 1995’s Forbes 500 list employ 20 million people. Assuming that 25 percent of them work overseas, that leaves a total of 15 million employees, or about 12 percent of the U.S. work force.
In addition, most calculations of CEO pay multiples exclude non-cash remuneration, such as company-paid FICA taxes and health benefits. These benefits cost companies considerably more for lower-paid workers than for CEOs, as a percentage of their total earnings.
Also, most CEOs put in considerably more hours (without overtime pay) than the average employee. A valid analysis of wage differentials should reflect differences in length of work week.
The average CEO of a $1 billion company-large enough to make the Forbes 500 has a 17.2:1 multiple. At a $100 million company, the average CEO pay multiple is only 8.6:1.
So let’s get real: Despite a few egregious examples, CEO pay levels are not out of line with what other employees earn.
WHY MOST COMPENSATION PLANS DISCOURAGE HIGH PERFORMERS
Most companies pay their employees similar amounts, with little difference from person to person based on performance. The reason: Employee pay plans lack the same considerable upside opportunity-and, conversely, downside risk-found in most CEO pay plans.
To measure the amount of risk in a CEO’s pay package, we can calculate its Pay Opportunity Index. This is the percentage difference in pay for outstanding performance, compared to good performance. For the typical CEO, the Pay Opportunity Index usually ranges between 50 percent and 100 percent. In other words, an outstanding performer would earn 50 percent to 100 percent more than a good performer. Such a high Pay Opportunity Index can be a tremendous incentive for outstanding performance.
By contrast, most employees have a Pay Opportunity Index of 5 percent to 10 percent (see table below). Take the typical $40,000 employee. Traditionally, he or she would be ineligible for stock options or other forms of equity-based pay. With good performance, that employee receives a 5 percent bonus and a 4 percent raise, for a total of $43,600. If outstanding, he or she gets a 7.5 cent bonus and a 6 percent raise, for a total of $45,400. The difference between the two pay packages is 4.1 percent. It may make sense to provide a $40,000 employee with more income security (and less opportunity) than a $400,000 CEO. But it makes no sense to expect a $40,000 employee to strive to be outstanding if the reward is a paltry extra 4 percent of pay.
Most Compensation Committees have done a good job of putting real opportunity into the pay packages of the CEO and the senior management team. Now it’s time to create bona fide economic opportunity for those in the trenches. Companies must change the focus of their employment deal from internal equity, that is, everyone earning the same, to differentiation, thereby aligning pay with contribution.
Jack L. Lederer is president of and Carl R. Weinberg is a partner in COMPO Consulting Group, a Westport, CT? based management consulting firm specializing in strategy, organizational effectiveness, and compensation.