CEO compensation: the whole truth.

Are CEOs greedy pigs with their trotters firmly planted in the money trough or hard-working, appropriately rewarded servants of corporate shareholders?

In the raging debate about compensation, these are the opposing views.

So which is it?

Today, CEO pay is no longer simply a market-based competition for talent. It's a key battlefield in the pay and income distribution warfare raging between employees and managers. It's the subject of bitter union and political criticism. And it's a visible target for a platoon of shareholder activists. Any CEO or board forgetting this is in for a rude shock.

Three red-flag issues inflame critics of CEO compensation packages:

1. Softball performance measures. 2. Underperformance compared with other companies. 3. Jumbo grants where modest market performance can produce large payouts.

NO STRINGS ATTACHED

Critics rant about boards approving risk-free compensation. Some point to long-tenured bosses receiving retention bonuses, or "sticking-around money," as it's described by Nell Minow, a principal of activist investment fund Lens Inc.

The weakness and, in some cases, lack of performance measures is a matter of considerable concern on both sides of the debate. A William M. Mercer survey showed that only a quarter of the option grants awarded to CEOs in 1995 contained any sort of link to performance.

There's also finger-wagging about cases where major corporations offer a risk-free platinum carrot to recruit an outsider as CEO. The Wall Street Journal, for example, cited Novell Corp., which recruited Eric Schmidt as CEO with "a stunning double mega-grant...with no performance strings attached," and AT&T, which recruited C. Michael Armstrong with "Teflon protection."

Yet statistics suggest that more companies are attempting to link pay to performance than ever before. As recently as 1980, the average stock option grant represented less than 20 percent of CEOs' direct pay, according to Brian Hall, an economics professor at Harvard Business School. By 1997, option grants accounted for 55 percent of total CEO pay, according to a survey of Fortune 200 firms conducted by Pearl Meyer & Partners, a leading firm of executive compensation consultants. In its 1999 Executive Pay Survey, Business Week calculated that "long-term compensation - mostly from exercised options - made up 80 percent of the average CEO's pay package [in 1998], up from 72 percent in 1997."

In 1997, Brian Hall and Jeffrey Liebman, an assistant professor of Harvard University's Kennedy School of Government, conducted a study of the correlation between CEO pay and corporate performance. They analyzed total CEO compensation packages and stock market value between 1980 and 1994 at 478 of the largest publicly traded companies in the U.S. They found that when stock and stock options are taken into account:

* CEO compensation is highly responsive to firm performance.

* CEO pay-to-performance sensitivity rose dramatically and by 1994 was about 30 times greater than previous estimates, which measured sensitivity of salary and bonus and ignored holdings of stock and stock options.

* While salary and bonus is "quite insensitive" to changes in firm performance, even here, the sensitivity between the two had "roughly doubled over the past 15 years."

* Poor performance does penalize CEOs financially, and penalties "both frequent and non-trivial."

* While not claiming that CEO contracts are efficient, or that pay-to-performance sensitivity is sufficiently high, Hall and Liebman conclude that "the fortunes of CEOs are strongly related to the fortunes of the companies they manage."

Other studies confirm these findings. In 1994, two M.I.T. economics professors, Paul Joskow and Nancy Rose, studied 1,009 CEOs in 678 firms between 1970 and 1990. They found that CEO pay grew "significantly more sensitive to firm performance during the '80s compared to the '70s, even when those portions of executive compensation derived from stock options and related instruments are excluded." They also found "virtually no support for the popular view that boards fail to penalize CEOs for poor performance or reward them disproportionately well for good performance."

CE's 12th annual survey of CEO pay in 1998 showed that, of the 189 responding CEOs, 18 percent "suffered declines in total cash compensation from 1996 to 1997 and 26 percent saw their total performance pay fall."

PERCEPTION VS. REALITY

In years past, the primary compensation concern was whether CEO pay was performance-based; today the question has become how a firm determines the strong performance that justifies bonus compensation. There's a striking need for firms to show clearly how CEO pay correlates with performance. Readily comprehensible trend charts, for example, help to demonstrate transparently, to supportive stakeholders and critics alike, precisely how pay relates to TSR and other relevant performance measures selected by individual companies.

In a 1998 report, Wayne Grossman, assistant professor of management at Kansas State University, and Robert Hoskisson, the Rath Chair in strategic management at the University of Oklahoma, observed that "much of the criticism leveled at incentive compensation is aimed at the performance standards to which executive pay is tied, usually accounting earnings and stock returns." They also concluded that it is "important for boards of directors, compensation consultants, and executives to understand how accounting and market performance measures behave within the context of overall firm strategy." In other words, boards and compensation committees must make sure that they define and apply credible and appropriate performance standards.

Option repricing is a justifiable flash-point for CEO pay critics. As Frederic W. Cook, an executive compensation consultant, points out, "Option repricings do not protect management from falling stock prices; they reward them for poor performance.... Those who support repricings, or acquiesce in their use, contribute to a public perception that executive compensation is a rigged game. This erodes shareholder support for stock options."

The simplest rule for boards and compensation committees to follow is never to reprice options. The public relations danger is simply too great and it will only feed the critics' worst suspicions.

SHARE THE WEALTH

Boards and compensation committees can help improve rewards for their employees and mitigate criticisms of CEO pay practices by spreading options across the organization, rather than letting CEOs receive the largest share. Executive Compensation Reports calculated that 51 percent of firms granting options for 1996 gave 10 percent or more of them to the CEO, compared with only 18 percent of those in 1993. CE's 1997 CEO compensation survey showed that 51 of the 219 companies in the survey granted at least 30 percent of their options to the CEO and other officers, "hardly a prescription for encouraging employee commitment."

Writing about the pay differential between CEOs and average employees, Cook commented, "The problem is not so much a pay gap as a return gap. The return to [shareholders] is much greater than the returns of those who invest their labor. Gaps of this magnitude probably are not sustainable over the long haul without serious employee unrest, conflict between investors and workers, and governmental intervention... The answer is not to reduce executive pay or shareholder returns but to raise the pay of average employees. Because this is not likely to occur in fixed pay and benefits, the best answer is to give all employees a stake in the company's performance through on-top profit sharing and stock options. In this way, the gap can be narrowed without a big increase in fixed costs."

Boards and compensation committees need to bear in mind that it's no longer good sense or good business to construct CEO compensation packages with little or no reference to compensation practices elsewhere in the same company.

Ultimately, any system of governance is only as effective as the individuals who implement it. As The Business Roundtable (BRT), an association of CEOs of leading U.S. corporations, remarked in its 1997 White Paper on Corporate Governance, "Directors can satisfy the most demanding tests for independence, but if they do not have the personal stature and self-confidence to stand up to a non-performing CEO, the corporation may not be successful."

THE BOARDROOM BULWARK

As BRT comments, "Good corporate governance is not a 'one size fits all' proposition, and a wide diversity of approaches to corporate governance should be expected and is entirely appropriate." The BRT observation is equally true of CEO pay.

Beyond indicating that CEO pay-for-performance schemes are doing their job, what other lessons can boards and compensation committees draw from available research? Boards and compensation committees constitute the most visible bulwark defending best practices for CEO compensation. If that bulwark is breached, governmental intervention could occur. Boards and compensation committees should bear in mind:

* The board of directors and compensation committee have a major responsibility to establish and maintain a CEO compensation package that rewards the CEO for performance against objectives, binds a CEO's interests to those of shareholders, and reduces a CEO's total compensation in the event of underperformance.

* All members of the board's compensation committee should be independent.

* CEOs serving on each other's boards should not serve on each other's compensation committees.

* To ensure objectivity, outside professional compensation consultants, working with the board and management, should report to the compensation committee.

More than ever, boards and compensation committees need to...

...be fully conversant with the key commercial, financial, and social drivers of a company in order to set realistic and transparent performance measures for a CEO in keeping with corporate objectives;

...monitor CEO and corporate performance diligently;

...implement the CEO compensation package evenhandedly;

...link the CEO's total performance-based compensation package closely to TSR;

...select a credible group of companies for pay and performance comparison, as required by the SEC;

...calibrate the CEO's pay realistically against the company comparison group;

...identify and monitor key supplementary performance measurements relevant to the firm's objectives, such as commercial, financial, social, and service quality criteria, or longer-term research and new product development criteria;

...specify and monitor appropriate stock ownership guidelines to maintain a credible relationship between the CEO's and shareholders' gains and losses;

...ensure that performance-based incentives are presented in such a way that their potential payoff is readily comprehensible to all concerned;

...consider the benefits of broadening participation in share ownership programs and coordinating performance measures throughout the firm, in order to focus the corporate culture on improving shareholder return and creating economic value.

...avoid repricing options.

If they do not adopt and implement such rules of the road, boards and compensation committees can expect to pay a price - such as "helpful" legislation that may be less flexible and substantially more onerous than the self-administered CEO pay principles outlined above.

While implementing these rules of the road will help rehabilitate the integrity and credibility of CEO pay for performance, no set of rules will satisfactorily answer the frequent question, "How much is too much?" In this context, boards, compensation committees, and CEOs might draw moral inspiration from the striking decision made by Pepsi's Chairman and CEO, Roger Enrico. In 1998 and this year, he donated his entire $900,000 salary to fund scholarships for Pepsi employees' children. Enrico's personal financial sacrifice, while small in relation to his total wealth, was far outweighed by the moral and motivational value of his gesture.

RELATED ARTICLE: Does Performance Pay Pay Off?

In addition to what's perceived as systemic overpayment, critics decry current CEO compensation for exacerbating an environment in which employees are increasingly disadvantaged by excesses at the top:

* According to a 1998 Business Week survey of 365 major U.S. firms, CEOs' average pay, including stock options, rose 36 percent in 1998 to $10.6 million, while earnings by S&P 500 companies fell 1.4 percent and factory employees' pay rose 2.7 percent. Average CEO pay had risen by 35 percent in 1997 and 54 percent in 1996.

* Some option plans include employees, but nearly a third of option grants in 1995 went to the top five executives, according to a report by the Investor Responsibility Research Center.

* The pay gap between CEOs and U.S. workers is on the rise. A recent Towers Perrin study of 292 Fortune 500 companies showed U.S. CEOs earning 185 times an employees' average pay, up from a ratio of 143 to 1 in 1992. According to the Economic Strategy Institute, the ratio of CEO pay to that of the average company workers rose from 60 times to 172 times between 1978 and 1995.

* The financier J.P. Morgan maintained that a CEO should never make more than 20 times the average employee salary. In the same vein, Congressman Martin Sabo (D-MN) introduced the Income Inequity Act of 1997, which denies tax deductions for CEO pay that exceeds 25 times that of the company's lowest paid worker.

But the income inequality argument is not that simple. Ken Deavers and Max Lyons, in their 1998 Economic Policy Foundation paper - "Does an Increase in Inequality Matter if Living Standards Are Rising?" - argue that "although inequality is increasing, living standards are rising across the entire income distribution.... In fact, since 1993 incomes for households in the lowest fifth of the distribution have risen faster than for any other group."

Nor are the claims of astronomic CEO pay multiples necessarily reliable. In a 1996 CE article, Jack Lederer and Carl Weinberg reported that the average CEO of a $1 billion company had a 17.2:1 pay multiple but, at a $100 million firm, the multiple was only 8.6:1. The argument that excessive pay for bosses impoverishes workers may be conventional wisdom but it doesn't make a decisive case.

Dilution resulting from the increased adoption of option plans also fuels pay cynicism. In a 1998 article for CE, Lederer and Weinberg noted that a few years ago, "few companies outside the high-tech world had an option overhang above 10 percent. Today it's not uncommon to see mainstream companies with option overhangs in the 15-20 percent range."

In 1990, according to the WSJ, stock options represented 5 percent of shares outstanding for large U.S. companies. By 1997, the number had risen to 13 percent. Several factors have encouraged this increased use of stock options. For example, under standard accounting rules, options, unlike cash, are not counted as a compensation expense, although companies must footnote them in annual reports using the Black-Scholes fair value option pricing model.

Despite conflicting views, there's a growing body of evidence that performance plans work. In their compensation survey of 211 CEOs for CE, Lederer and Weinberg found that the 23 companies that granted at least 95 percent of their 1997 options below the five named officers outperformed industry peers by an average of 310 basis points.

Examples abound. Herman Miller, Inc., adopted the ScanIon system of participative management and gain-sharing in 1950. The company created a PAYSOP program in 1983, which provides for all employees of more than one year to own stock. In 1996, the company adopted a performance measurement and compensation system called "Economic Value Added" (EVA), which links operating and financial performance to compensation for all employee-owners. Since adopting EVA, Herman Miller's market capitalization rose from approximately $750 million to more than $3 billion.

Steel producer Nucor uses companywide incentive plans and eschews employment contracts for senior officers, profit sharing, pension, discretionary bonuses, and retirement plans. If Nucor does well, an officer's compensation is above average. If Nucor does poorly, an officer's compensation is a base salary below average industry compensation. In Silicon Valley, tech firms spread options liberally among workers in lieu of huge pay increases.

Unfortunately, many mainstream firms have not spread the wealth, but much pay criticism could be alleviated if stock options were widely available among employees.

RELATED ARTICLE: Market-Made Megapay

While notorious examples of excessive pay produce reactions of disbelief, dismay, embarrassment, anger, or even envy, instances of wretched excess aren't an accurate barometer of CEO compensation. Common sense alone suggests that the enormity of these cases makes them the exception.

However, this may not make a difference if, at the end of the current bull market, boards and compensation committees engage in an orgy of CEO compensation increases. Critics are already saying that some boards don't understand CEO incentive pay packages. There's even an insinuation of "pay blackmail" that stems from the brand value of an "irreplaceable" CEO. If voters feel CEOs are overpaid, they will support pay limitations. CEOs should be aware of this and act carefully. Yet, each CEO has a different set of market-based circumstances that influence compensation, which makes acting in concert difficult. Moreover, a small number of CEOs who make no effort to restrain compensation will inevitably spoil it for the rest, who are not as well compensated.

The CEO pay multiple, or total CEO pay divided by the average employee's total pay, is one measure used to prove that CEO compensation is out of whack. Business Week's Annual Executive Pay Survey noted that CEO pay rose from 44 times the average pay of factory workers in 1965 to 326 times the average pay of factory workers in 1997 and to 419 times the average blue-collar wage in 1998.

This year, Business Week reported that "the head honcho at a large public company made an average $10.6 million last year. That's a 36 percent hike over 1997." Last year's survey had noted a 35 percent increase in CEO pay from 1996 to 1997. At the same time, executive compensation literature is replete with egregious examples of alleged overcompensation. Consider Charles B. Wang, the longtime CEO of software firm Computer Associates. His pay arrangements caught the attention of compensation expert Graef S. "Bud" Crystal.

Crystal examined Wang's salary, bonus, grants of free shares, option grants actually taken, unexercised stock option paper profits, and other compensation and calculated that, during the three fiscal years ending March 31, 1998, Wang earned $430 million. Crystal noted that Computer Associates' stock closed above $53.33 per share for the 60th day in a 12-month period on May 21, 1998, triggering an additional award of "12.15 million free shares worth $670 million." This award was based on his performance between May 17, 1995, when his board approved the incentive plan, and May 21, 1998, when he received them. Acknowledging that, technically, the share grant wasn't earned until just after the start of fiscal 1998, Crystal adds the three-year earnings of $430 million to the $670 million in shares granted and gets "a grand total of $1.1 billion for three years of work, or an average of $367 million per year, or $143 million a year."

This case illustrates some of the emotional issues characterizing the debate. As Crystal himself observed, Computer Associates' compound annual total shareholder return over a 14-year period beat the S&P index by about two-to-one and its stock price rose 14-fold in the previous five years. Yet Crystal asserts, "If the compensation committee members who approved the plan back in May 1995 had really understood how it would work, we seriously doubt that they would have approved it."

The furor is just as loud over payments to top executives who are terminated or pull their platinum ripcord. Infamous examples include Michael Ovitz's $90 million from Disney, John Walter's $26 million from AT&T, and Gil Amelio's $6.7 million from Apple Computer.

In this era of increasing shareholder awareness, the impact and implications of cases such as this - and the publicity they generate - should not be lost on boards. In an environment where critics charge that the long-running bull market has produced excessive rewards for mediocre CEOs, there's an urgent need for compensation committees to understand pay-for-performance metrics and evaluate plans in place.

Denis Lyons, senior director in Spencer Stuart's New York office, specializes in CEO searches.