Harnessing corporate horsepower: the new principles of CEO compensation.

The new principles of CEO pay emphasize ownership, value-enhancing growth, and external benchmarks of performance.

We knew that a few CEOs still thought they could play by the old compensation rules when one of them urged us to drop him from our survey for fear that his company's non-calendar fiscal year might somehow distort the value of his pay package. (We didn't.)

Although this CEO may not realize it, the principles have changed for CEO compensation. What once may have been tolerated (if not endorsed) - guaranteed contracts, high pay for mediocre performance, and ambiguous disclosure - does not fly in today's environment. Shareholders now expect CEOs to risk their pay on their ability to perform, to invest their own money in the business, and to provide candid disclosure of both.

Chief Executive's ninth annual compensation survey, which analyzed the annual reports and proxy statements of 232 companies, reveals that an increasing number of chieftains are doing just that, accepting - in some cases, even seeking - both pay-for-performance and more substantial downside risk. While a handful of companies, including Exxon and PaineWebber, appear locked in the low-risk, high-reward model of the 1980s, others, such as General Mills, General Re, Quaker Oats, and Aetna, have embraced the new philosophy, measuring performance relative to either a peer group or a competitively derived benchmark.

Some even seem ready to begin to push these principles throughout the management hierarchy, requiring the board; the CEO's senior lieutenants; and, in some cases, the entire organization to accept pay-for-performance principles. This healthy impulse - driven by increasing SEC pressure for disclosure and stepped-up scrutiny by shareholders and activist boards of directors - can be summed up in a simple phrase: No more guarantees.

THE NEW WAY

Historically, compensation committee discussions usually concentrated on the issue of pay levels. Most committees focused on one underlying question: How does our CEO's pay level compare to that of his peers? If there was a gap, the committee bridged it, usually by increasing the CEO's pay package.

As a result of this "competitive-pay" approach to compensation design, most CEO pay packages used to follow certain rules:

* Compensation levels were tied to company size, thus encouraging revenue growth with little regard for how such growth might affect shareholder returns.

* Fixed elements - salary, guaranteed minimum bonus, perquisites, retirement benefits, and so forth - were relatively high compared with variable elements such as at-risk bonuses, long-term performance plans, stock options, etc.

* Equity-based elements such as stock options and restricted stock lacked true risk, because the CEO rarely invested his own money - either explicitly by purchasing shares, or implicitly by withholding cash compensation.

* Performance targets were based on the budget, which encouraged conservative forecasting and reduced the riskiness of the pay package even further.

While compensation committees still care about the competitiveness of the CEO's pay, the topic is of secondary importance today. The critical questions committees ask now are: How does our company's performance compare to our peers'? And how does our CEO's pay reflect our relative performance? This "comparative-performance" philosophy has dramatically changed the principles of CEO compensation-package design.

1) While revenue size may help determine the target value of the pay package, its delivered value depends on achieving superior shareholder returns.

2) Most of the total pay opportunity is delivered through performance-based vehicles, with a relatively small portion through fixed elements.

3) CEOs become partners of the shareholders by investing their own capital, either through stock purchases, exchanges of cash compensation for options or stock, company matches of shares received upon exercise of options, and other ownership-enhancing programs.

4) Instead of using the budget as the performance benchmark compensation committees require CEOs to outperform the company's peers.

5) Annual bonuses reward building value through formulas that include a charge for the use of capital.

1994: A BELLWETHER YEAR

In 1994, it became clear that most companies had adopted the new principles. Total performance pay increased in 11 of 16 industries, generally reflecting strong industry profits and the increased use of variable compensation. Retailing, on the other hand, experienced a double-digit decline in CEO pay, reflecting the industry's erosion in profits and -11.5 percent return to shareholders during the year. (Exhibit I compares 1993 and 1994 competitive compensation levels for each industry.)

PRINCIPLE ONE: SHREHOLDER RETURNS

Industrywide statistics only partly tell the story. To really understand how CEO compensation is changing, we studied the data on a company-by-company basis. Our review of pay leverage (see Exhibit II) demonstrates that compensation committees increasingly are linking [TABULAR DATA FOR EXHIBIT I OMITTED] CEO pay to shareholder returns. Our Leverage Index measures the sensitivity of the CEO's compensation package to a doubling in the company's stock price. Compensation committees should aim for a Leverage Index of at least 2.00, which means that if a company's stock price doubles, so would the value of the CEO's pay package.

For the first time since we began tracking the Leverage Index, more than 50 percent of the CEOs in our survey - 129 of 232 - had a Leverage Index above 2.00. Just as important, only 28 percent fell in the low-leverage categories below 1.50. This is a complete reversal from just three years ago. In 1991, only 33 percent of the companies were above 2.00, with 44 percent below 1.50. Compensation committees today increasingly are adopting the first new rule of CEO pay by linking CEO earnings to shareholder returns.

PRINCIPLE TWO: NO MORE GUARANTEES

The second principle of CEO pay emphasizes performance-based compensation vehicles over guarantees. Again, company-by-company data show how rigorously compensation committees are applying this principle. Of the 200 CEOs in our study who held the job in 1993, an astounding 54 of them - 27 percent - received no salary increases in 1994. Ten even reported salary cuts. One of the most noteworthy is T. Milton Honea Jr., of Houston-based Noram Energy, whose reported salary declined from $347,000 in 1993 to $199,000 in 1994. Disappointed with his company's below-industry shareholder returns over the 1990-1993 period (it should be noted that he became CEO in December 1992), Honea nevertheless demonstrated his confidence by trading his salary for restricted stock. (He received enough in cash to cover his tax liability on the shares.) His entire bonus award of $300,000 also was paid in company stock. Honea's example hopefully will play a major role in encouraging other utility-company CEOs to link their pay to shareholder returns.

Many CEO pay packages used to provide plenty of performance-linked upside earnings potential, but not enough downside risk. Our research indicates that the low-risk, high-reward days are ending fast. For example:

Almost 30 percent of the CEOs in the study - 59 of 200 who were also CEOs in 1993 - experienced declines in total cash compensation (salary plus bonus) in 1994.

In 68 cases (or 34 percent), the value of the total pay package declined from 1993.

Fewer than 13 percent received perquisites in excess of the reportable level ($50,000), compared with 16 percent in 1993.

While 191 (or 82 percent of the 232) companies in the study provide the CEO with a non-qualified supplemental retirement benefit (not surprising, given the $150,000 cap on pensionable earnings), the majority (64 percent of the 191) merely extended the qualified benefit formulas to earnings above the cap, rather than providing the CEO with a special deal of his own.

In perhaps the most dramatic statistic of all, 38 of last year's 238 CEOs no longer held the job by the end of 1994, for a turnover rate above 16 percent. While some of these turnover situations arose from normal retirement, many resulted from either acquisition or performance-related termination. Clearly, CEOs have far less pay security and job security than they did a few years ago.

Unfortunately, some compensation committees remain stuck in the low-risk, high-reward model of the 1980s. At first glance, it appears that Lee R. Raymond, CEO of Irving, TX-based Exxon, was taking a big risk by receiving 200,000 stock options as part of his 1994 pay package. This helped drive his Leverage Index to 5.06, third highest in his industry group. But a closer look reveals that Exxon's pay philosophy might be described as "win big if you perform, win anyway if you don't." How else can one explain Raymond's $1.3 million salary, which exceeds competitive practice by 19 percent, or his restricted stock grant of $593,000, which he receives as long as he completes his career as an Exxon employee?

New York-based PaineWebber is another example of "riskless risk-taking" by a highly paid CEO. In its proxy statement, the compensation committee highlighted the 63 percent decline in CEO Donald Marron's 1994 bonus and restricted stock grant, which it attributed to a fall in performance. Nonetheless, Marron received bonuses and restricted stock awards totaling about $2.7 million, plus 400,000 stock options. Where's the risk?

PRINCIPLE THREE: OWNERSHIP ENHANCEMENTS

The third principle of modern CEO compensation practice is to enhance and encourage ownership of company stock. Fully 11 percent of the surveyed companies mention ownership guidelines in their proxy statements. Independent research indicates that the total with such guidelines is probably closer to 25 percent. CEO ownership guidelines typically range between three and eight times base salary.

Some compensation committees create the guidelines but do little to enable the CEO or other executives to achieve them. Other companies have wisely implemented programs that facilitate employee ownership. As we reported last year, Minneapolis-based General Mills leads this area, with its options-for-salary exchanges, deposit shares, and broad-based stock-option grants. Many companies report similar programs. For example, Ronald E. Ferguson, CEO of Stamford, CT-based General Re, exchanged part of his annual bonus for restricted stock options. These options are immediately exercisable, but the underlying shares cannot be sold for five years from the grant [TABULAR DATA OMITTED] date. The compensation committee also required Ferguson to receive part of his bonus in restricted stock, a program that is voluntary for other executives but mandatory for the CEO. Similarly, Arnold G. Langbo, CEO of Kellogg's in Battle Creek, MI, received 10,000 stock options in lieu of a portion of his annual bonus.

Chicago-based Quaker Oats has one of the boldest programs for encouraging employee ownership. Under its incentive investment program, 720 key managers invest up to 20 percent of their annual bonus in company stock. The company matches the investment with two restricted shares for every three shares purchased, with the restricted shares vesting 50 percent after three years and the remainder after five years.

EXHIBIT II
LEVERAGE INDEX

INDEX                      1994             1993

2.00 AND ABOVE              129              113
1.75 TO 2.00                 17               25
1.50 TO 1.75                 22               20
1.25 TO 1.50                 14               22
1.00 TO 1.25                 50               52
TOTAL                       232              232

Note: Leverage Index is a measure of the degree to which the value
of the pay package is dependent on stock appreciation.

PRINCIPLE FOUR: PERFORMANCE VERSUS PEERS

The fourth principle focuses on measuring performance. Traditional bonus programs rewarded CEOs for achieving budget. This approach corrupted the budgeting process, discouraged management from innovation, and ignored the competition.

The new philosophy measures performance relative to either a peer group or a competitively benchmarked performance standard. At Chicago-based Wrigley, a stock-grant program awards shares based on a comparison of the company's total return to shareholders to that of the S&P Food Index. Aetna, headquartered in Hartford, CT, awards shares based on the company's total return performance versus that of the Dow Jones Insurance Index. The Aetna program also establishes a minimum performance threshold equal to the prevailing risk-free interest rate before any shares are awarded, regardless of performance relative to the peer group.

PRINCIPLE FIVE: PAY SHAREHOLDERS FIRST

Ten years ago, many CEO bonus plans were based on achieving pre-established increases in earnings-per-share. While this remains a common measure, companies increasingly are applying the fifth and final principle of modern CEO compensation design: charging the management team for the costs of capital. This encourages the CEO to look for growth opportunities that will increase shareholder value, not the CEO's empire.

Some companies, such as Atlanta-based Coca-Cola and Pittsburgh-based H.J. Heinz, have installed formal economic-value-added programs to measure and reward management for shareholder-enhancing growth. These programs can be effective, but they also can be complicated to formulate/difficult to communicate, and expensive to install and maintain. In many respects, Michael D. Eisner, CEO of Burbank, CA's Wait Disney, has the simplest and most effective EVA-style bonus program of all. His annual base salary has remained fixed at $750,000 since 1989. In addition, he receives 2 percent of the company's net income in excess of a return on equity of 11 percent. In 1993, the company failed to meet the ROE threshold, and Eisner received no bonus. In 1994, his bonus was about $7.2 million, equal to 2 percent of the company's $363 million in net income in excess of the threshold. When shareholders benefit, Eisner wins big. What could be simpler or more effective?

THE SEC'S INFLUENCE

Why have the rules changed for CEO compensation - and why so quickly? While shareholder activism has played a role, the SEC has been the principal instigator. The new proxy statement disclosure requirements have forced every reporting company to take three critical steps: first, to disclose CEO compensation concisely and consistently, facilitating comparisons from one company to another; second, to compare its shareholder performance to peer companies, exposing examples of misalignment between pay and performance; and third, to articulate the compensation committee's rationale for its decisions, which has increased the analytical rigor of many committees.

The SEC's contributions contrast strongly with misguided attempts by both the Financial Accounting Standards Board and Congress to influence executive compensation. Essentially, the SEC instructed companies to provide straightforward information about pay and performance, so investors could make up their own minds. Both the FASB and Congress tried to punish companies for selecting disfavored (in their view) compensation vehicles: stock options in the FASB's case, and non-formula-based incentives in Congress' case.

Fortunately, the punitive approach has failed: The FASB has abandoned its proposed new rules for stock-option accounting, and most companies have successfully exploited loopholes in the rules governing tax deductibility of executive compensation. Meanwhile, the SEC's disclosure requirements have encouraged many companies to change for the better - the prevailing philosophy underlying their executive compensation programs.

MOTIVATING EMPLOYEES

Although a handful of companies remain trapped in the past, most compensation committees are finally getting CEO pay right. Today's CEO pay packages contain risk, encourage partnership with shareholders, and use external benchmarks of performance.

Now companies face a new challenge: how to apply the philosophy guiding CEO compensation to the rest of the organization. Re-engineering has forced employees to work in teams and reduce fixed costs, but most compensation systems still follow the archaic model of individual bonuses and across-the-board merit pay raises.

The key is to help employees develop meaningful ownership stakes, based on the contributions they make to the business, while recognizing that they cannot afford the same financial risk as the CEO and senior management. Companies have many tools for accomplishing this, such as broad-based stock-option plans, matching share programs, ESOPs, and 401(k)s. The CEO's challenge is to select the programs that - while helping employees become owners - will also motivate them to think and act like owners.

Jack L. Lederer is president of and Carl R. Weinberg is partner in COMPO Consulting Group, a Westport, CT-based management consulting firm specializing in compensation, organizational effectiveness, and executive development.

RELATED ARTICLE: METHODOLOGY AND TERMS

CEO pay data for the most recent fiscal year were analyzed from annual reports and proxy statements for a sample of 232 companies that represent a cross section of small, medium, and large companies, and low, medium, and high performers in 16 separate industries. Our analysis is based on the CEO as of the close of the company's fiscal year.

Company Performance equals annualized total return to shareholders for the 1991 to 1994 period. (As a simplifying assumption, dividends are not "reinvested," unless significant payouts have resulted from capital restructuring.)

Competitive Pay is calculated through regression analysis ("lines of best fit"), comparing revenues with CEO pay for each company in an industry group.

Actual Pay is salary, annual bonus, and the expected value of long-term incentives:

* Options are valued using the "extended" binomial method. We adjust this calculation as follows: We discount option values 25 percent for illiquidity and for the risk of forced early exercise following termination. We discount the option value 5 percent per year over the weighted average vesting period to reflect forfeiture risk. If the proxy statement does not disclose vesting, we assume an average vesting of three years.

* Restricted shares are assigned face value, discounted 5 percent per year for the average vesting period to reflect forfeiture risk. If the proxy statement does not disclose vesting, we assume five years.

* Performance units and performance shares are valued at target, discounted to reflect forfeiture risk like restricted shares. If performance shares are at maximum, we discount an additional 25 percent for performance risk. This valuation approach captures the expected value of long-term incentives at the time of grant.

Pay Factor is the percent difference between Actual and Competitive Pay.

Performance Factor is determined by subtracting the median Industry Performance from Company Performance.

Return Above/(Below) Industry is the difference between the growing market value of the company at the Company Performance rate versus the Industry Performance Rate.

Pay Above/(Below) Competitive is the dollar difference between Actual and Competitive Pay.

Pay Premium (Penalty) per $100 in Performance is calculated by dividing Pay Above/(Below) Competitive by Return Above/(Below) Industry/$100.

NM relates to companies in which pay and performance are not aligned. Linkage is absent.

Leverage Index is the ratio of Actual Pay assuming a 15 percent annual stockprice growth rate, and Actual Pay assuming a 0 percent annual stock-price growth rate.

CEO Capitalization Index is a measure of ownership calculated in the same way as the Leverage Index, except that the numerator includes the appreciation in value of all options and shares held.