CEO compensation: greed or glory?

IT'S BEEN ANOTHER BANNER YEAR FOR CEO PAY - AND FOR PUBLIC OUTCRY OVER THE HEFTY PAY PACKAGES THE NATION'S BUSINESS LEADERS ARE TOTING HOME. THE WALL STREET JOURNAL DUBS IT "GREED GONE WILD," WHILE BUSINESS WEEK ASSERTS, "IN TODAY'S MARKET, THE ONLY TRUE CONCLUSION IS THAT IF GREED IS GOOD, IT'S BEST FOR THE CEO." BUT IN THEIR HASTE TO RANT ABOUT FLAGRANT GREED, PAY CRITICS ARE OVERLOOKING CRUCIAL POINTS. CLOSER EXAMINATION OF TODAY'S SOPHISTICATED COMPENSATION FORMULAS SHOWS THAT PAY AND PERFORMANCE ARE LINKED MORE CLOSELY THAN EVER AND SUGGESTS ANOTHER LINK - BETWEEN AMERICA'S CEO PAY STRATEGY AND THE NATION'S ECONOMIC GROWTH.

Once again this spring, thousands of companies mailed out their proxy statements, and the nation's business press unleashed a ferocious attack on CEO pay levels. Fortune, Forbes, The New York Times, Business Week all got into the act. The Wall Street Journal's opening words endorsed the "greed gone wild" theory, stating: "Pay for performance? Forget it. These days, CEOs are assured of getting rich - however the company does."

According to the business press, excesses in CEO pay undermine the strength of the U.S. economy in three ways. First, they divert value from shareholders through excessive dilution. Second, CEOs make short-term decisions that inflate the company's stock price, which then crashes after they exercise their options and sell their shares. Third, employees feel alienated from the boss, which leads to lower productivity, as well as an absence of commitment and creativity.

There's only one small problem with the theory of "greed gone wild." The U.S. economy is the envy of the world - the only major one to flourish over the last few years. The question is: Does the U.S. economy grow despite the excesses of CEO pay? Or does America's philosophy of CEO compensation provide U.S. companies with a global competitive advantage?

According to research conducted by PricewaterhouseCoopers for Chief Executives 12th annual survey of CEO compensation the high-risk high-opportunity CEO pay strategy used by most major American companies is a secret weapon contributing to the unprecedented recent growth of the U.S. economy. The survey, which covered 320 companies in 17 industries, indicates that the prevailing CEO pay strategy is a lot more sophisticated than the simplistic "greed gone wild" description it receives in the press. Rather than demonstrating rampant greed, today's CEO pay packages have helped the U.S. achieve glory as the unchallenged leader of the world's economy.

CEO PAY IN 1998

In reality, CEO pay has never been so closely aligned with performance as it was in 1998. For the 280 CEOs in our study who also held the job in 1997, the median increase in total cash compensation was only 5.4 percent - an unsurprisingly modest gain, given the lackluster growth in corporate earnings. Nearly half of these CEOs - 117, or 42 percent - experienced declines in total cash compensation in 1998, and in most cases they led companies whose 1998 performance lagged their industries.

CEO-pay critics point to other statistics when they assert that CEO compensation continues to escalate out of control. The median base salary increase in our survey was 6.5 percent, almost double the national average of between 3 percent and 4 percent. Also, the median Total Pay increase was 8.5 percent. How can CEO pay be related to company performance, the critics argue, if it increases almost 10 percent in a year of weak corporate profits?

With a more sophisticated analysis of the data, the pay-performance linkages become clear. Today's CEOs often receive salary increases every other year, resulting in bigger increases. In fact, 82 of the 280 CEOs - or 29 percent - failed to receive an increase in base salary in 1998. Similarly, many companies today make option awards every few years, resulting in large swings in total pay. This is one reason why 116 CEOs - or 41 percent - experienced declines in total pay from 1997 to 1998.

Our Leverage Index chart illustrates this pattern of larger, less-than-annual option grants. The Leverage Index measures the sensitivity of the CEO's pay package to growth in the company's stock price. A Leverage Index of 1.00 indicates no sensitivity; 2.00 means the package is worth twice as much in five years if the stock price doubles. In our judgment, compensation committees should aim for a minimum CEO Leverage Index of 2.00.

In 1998, 244, or 76 percent, of the 320 CEOs in our study had a Leverage Index of 2.00 or more - an increase from 71 percent in 1997. At the same time, the percentage of CEOs with a low Leverage Index - 1.25 or below - remained at 14 percent. Viewed together, these two trends provide strong evidence that CEOs today receive larger - but less frequent - stock incentive grants, thus encouraging them to focus on shareholder returns instead of negotiations with their compensation committees.

LEVERAGE INDEX

INDEX                   1998          1997

2.00 and above          244           226
1.75 to 2.00             15             8
1.50 to 1.75             11            20
1.25 to 1.50              4            19
1.00 to 1.25             46            47

TOTAL                   320           320
CAPITALIZATION INDEX

INDEX                    1998          1997

20.00 and above          160           130
10.00 to 20.00            92            93
5.00 to 10.00             44            63
1.00 to 5.00              24            34

TOTAL                    320           320

SIX BEST PRACTICES

Our research has identified six CEO pay practices that have helped vault our economy from weakness in the '80s to leadership in the '90s. While few companies employ all six practices, they serve as benchmarks that less successful companies can use in redesigning their pay programs. The six best practices are:

* By increasing the CEO's pay opportunity, the Board has greater license to demand results - and take action when the CEO fails to perform.

* Significant stock option grants have made CEOs far more willing to make hard choices that ultimately create substantial shareholder value.

* As concerns emerge about the stock market's ability to sustain its recent performance, compensation committees are approving innovative "balanced scorecard" pay designs that help position their companies for sustained long-term growth.

* Boards are encouraging their CEOs to shift the mix of their pay from cash to options, thus strengthening the alignment between pay and performance.

* To address the concern of institutional investors that a rising stock market lifts all boats, many companies now measure performance against a group of peers and reward their CEOs accordingly.

* Despite the criticisms they have received in the business press, career awards of stock or options encourage CEOs to take the long view as they make strategic and tactical decisions.

HIGH PAY AND LITTLE PATIENCE

Each week, The Wall Street Journal reports that another CEO has either been dismissed or has resigned "for personal reasons" or "to pursue other interests." That's the quid pro quo for the substantial pay opportunities CEOs receive today - boards have little patience when facing poor performance.

Forty of the 320 companies in this year's survey replaced their CEOs in 1998. Undoubtedly some of these replacements were normal retirements, but many were triggered by impatient boards unwilling to bet shareholder value on a CEO who no longer held their confidence. In some cases - for example, the dismissal of Eckhard Pfeiffer at Houston-based Compaq Computer - declining expectations may [TABULAR DATA OMITTED] have driven the Board to action, even though past performance had been strong. In other countries, CEOs don't receive the extraordinary incentives offered by U.S. firms, but they have little to fear in terms of job security. Is it any wonder American CEOs push their companies to innovate and grow?

HARD CHOICES

Today's investors expect a CEO to make hard choices that change the company's strategic direction. In better practice companies, the CEO's pay package provides substantial rewards when the strategic repositioning succeeds and penalties when it fails. Unlike many counterparts overseas, U.S. CEOs often make difficult strategic decisions that lead to significant long-term creation of shareholder value.

As an example, consider the performance - and pay - of C. Michael Armstrong, chairman and CEO of AT&T (see cover story, p. 36). Few CEOs have faced a more difficult challenge than he did when he took over the company's leadership a few years ago. Appropriately, most of the value of his 1998 pay package is wrapped up in grants of 300,000 options and 25,000 performance shares - value that he will realize only if he continues to achieve results as he has so far, with total shareholder returns of 53.7 percent in 1997 and 26.2 percent in 1998. Just as important, AT&T's Board requires him to own company stock worth five times his base salary, or $7 million. These ownership requirements reinforce the CEO's commitment to shareholder value creation, because of the substantial portion of his own wealth at stake.

In contrast, it's hard to understand the 1998 pay package received by Coca-Cola's CEO, Douglas Ivester. Shareholders earned returns of 1.3 percent for the year, compared to an industry median of 10.4 percent. Yet Ivester received a discretionary bonus of $1.5 million compared to a formula bonus in 1997 of $2 million, and restricted stock worth $16.8 million compared to 1997's $8.8 million. His 1997 promotion to the CEO post notwithstanding, it's hard to see the direct connection between 1998 pay and 1998 performance.

BALANCED SCORECARD PAY DESIGNS

Options encourage the CEO to grow the stock price, but they have two weaknesses when they serve as the only long-term incentive vehicle. First, supplied with enough options and an upward-trending market, even a mediocre CEO can become rich. Second, options focus on the ultimate objective - stock price performance - without any concern for how to achieve it, thus rewarding decisions that propel the stock price in an unsustainable way.

Because of this, some forward-thinking companies combine their stock option programs with other long-term incentives that reward the CEO for achieving a broad variety of strategic and operational objectives-hence the term "balanced scorecard." Coca-Cola Co. has had a program like this for years, which rewards executives for three-year growth in two critical predictors of long-term shareholder value creation - unit case sales and economic profit. Another example is Kimberly-Clark, whose long-term incentive program discourages decisions that might boost the stock price in the short run and punish it in the long run. In addition to stock options, CEO Wayne R. Sanders receives five-year Book Value Appreciation Rights, which pay an amount equal to the increase in Book Value per Share, with dividends "reinvested" into additional Book Value shares. Because of this program, executives know that they can still be rewarded for good strategic decisions, even if the paper products sector falls out of favor with investors.

FROM CASH TO OPTIONS

Many studies have documented the enormous rise in the size of stock incentive awards over the last several years. Ten years ago, few mainstream companies outside the high-tech arena granted options on more than 1 percent of shares outstanding per year. Today many companies routinely grant between 1.5 percent to 2.0 percent per year. Similarly, companies used to remain below a 10 percent ceiling in option overhang, which is defined as options outstanding plus options authorized for future grants, as a percentage of shares outstanding. Today, it's not unusual to see non-high-tech companies with 15 percent overhang or higher.

According to pay critics, increases in [TABULAR DATA OMITTED] stock incentive awards are no-risk giveaways because they supplement the traditional pay packages CEOs and other executives already received. This assertion ignores the growing number of companies that encourage CEOs to exchange cash compensation for additional options and restricted stock. General Mills and the Kellogg Co. have had programs like these for many years. So do many other companies. For example, Sara Lee Corp. substitutes performance share grants for both salary increases and executive perquisites. At Fruit of the Loom, CEO William Farley exchanged three years of base salary, worth $950,000 per year, for additional stock options. Similarly, Sumner Redstone, CEO of Viacom, exchanged his entire salary and bonus for additional options.

As noted, one of the weaknesses of a stock option-only approach is that it rewards the CEO of a company whose stock price grows while underperforming its peers. Many companies compound this problem by using internal benchmarks to establish performance targets for bonus plans. These compensation programs forget that the investment community compares a company's performance to others in its industry, as well as to broad market indicators like the S&P 500 Stock Index.

In recognition of these concerns, many compensation committees have approved programs that link CEO rewards to the company's performance against peers. For example, Mobil Corp. measures performance vs. peers in both its annual and long-tenn incentive plans, with performance measures including earnings-per-share growth, return on capital employed, and total return to shareholders. At Campbell Soup Co., all incentive plans - even the size of the 401K match - are based on performance vs. peers. At Bestfoods, performance unit awards vest based on total return to shareholders vs. a peer group. While these programs differ in detail, they all share a common objective - to ensure that the CEO is rewarded for beating the competition, not just for being along for the ride.

Unfortunately, some compensation committees approve incentive programs that seem to give the appearance of raising the bar without substance. For example, consider the stock option plan at Dole Foods. Ten-year options vest early if the company achieves certain stock price hurdles. So far, so good, until one realizes that 100 percent vesting occurs once the stock price has grown 35 percent, which over a five-year period is a compound return of only 6.2 percent. Is this the stretch goal that the program is meant to suggest?

STAYING POWER

Over the last few years, pay critics have attacked mega-grants of stock options and restricted stock as a giveaway to CEOs, because the size of the grant guarantees a large payout even for mediocre performance. The critics ignore the fact that these grants are frequently intended as one-time career awards that replace several annual awards. These awards frequently vest at retirement, thus ensuring retention of the CEO for the balance of his career.

Executives at Procter & Gamble, for example, receive a portion of their annual bonus in restricted stock that vests at retirement. Over the years, the accumulation of unvested restricted stock discourages P&G executives from jumping to a competitor. Exxon Corp. grants CEO Lee R. Raymond "career shares" that vest at normal retirement age.

Another example is the 1997 grant of 2.6 million stock options received by Reuben Mark, CEO of Colgate-Palmolive Co. The grant covered seven years of future grants, with exercise prices as high as 70 above market on the date of grant. To underscore the connection between pay and performance even further, the options expire five years following the grant if the company fails to meet its stock price targets. When Colgate-Palmolive announced the award, several pay critics singled it out as an example of CEO pay excess. But in our view, it's an example of a well-designed program that provides substantial rewards only if the company performs well for its shareholders.

Overall, U.S. firms challenge and reward their CEOs in a way that differs fundamentally from the approach used virtually everywhere else in the world. American CEOs face far greater risk - and enjoy far greater wealth creation opportunity - than their counterparts around the globe. It is time to stop complaining about the alleged excesses of this country's model for compensating CEOs, and time to recognize it as one of the reasons why the American economy continues to prosper and grow.

Note: Firms listed are excerpted from the PricewaterhouseCoopers CEO Compensation database. Competitive pay data is based on the entire database.

Carl R. Weinberg is principal at PricewaterhouseCoopers Global Human Resource Solutions. Mandi Mazza and Susan Lowry also contributed to this article.