Largesse oblige.

Fueled by strong corporate profits, rising stock prices and, in some cases, pure greed, CEO pay is higher than ever. Raging against the tide, critics decry escalating compensation, terming some packages "obscene." Defenders counter that any amount is reasonable - as long as pay is tied to performance. But both sides miss out on the real issues.

Earlier this year, at a Compensation Committee meeting we attended, a point was raised that summarized today's boardroom debate over executive compensation. While discussing the dilution of the proposed new option program, the Committee Chairman looked a major shareholder straight in the eye. "Stop worrying about how much you might be giving up," he said, "and start thinking about which employees can help you build the value of what you have."

CEO pay continued to escalate in 1996, provoking critics to bemoan CEO greed and Compensation Committee complicity. However, as Chief Executive's 11th annual survey of CEO compensation shows, the loudest CEO pay critics have once again overlooked the two major issues in today's executive compensation landscape - the continuing extension of options throughout the organization, and the imbalance in too many CEO pay packages between upside opportunity and downside risk.

Last year, our compensation feature story encouraged Compensation Committees to stop piling options on the CEO and his lieutenants, and instead to provide equity-based pay opportunities to all employees who help create value - wherever they might be in the organization. This year's survey provides many examples of companies that are, in fact, sharing the wealth by using options as a principal vehicle for creating broad-based employee commitment and excellence. However, it also spotlights too many Compensation Committees that are unwilling to expose their CEO to the same risks shareholders face.

Our research indicates that CEO pay today increasingly depends on company performance-more than at any time in the modern corporate era. Just as important, more Compensation Committees than ever before are insisting that strong shareholder returns become the CEO's principal route to personal wealth creation.

Our exclusive Leverage Index analysis is a good place to observe the continually strengthening relationship between CEO pay and company performance. It measures the sensitivity of the CEO's pay package to growth in the company's stock price. We strongly encourage Compensation Committees to make sure their CEO's Leverage Index exceeds 2.00 - which means that if the stock price doubles, so does the CEO's pay.

Seventy percent of the 219 companies in our survey had CEO Leverage Indices over 2.00. This compares with 60 percent in 1995 and only 56 percent in 1994. Even more astounding, 47 percent of the 219 companies had Leverage Indices above 3.00 - compared to 38 percent in 1995 and only 27 percent in 1994. This indicates a dramatic increase in the alignment of CEO earnings with company stock performance. However, the real question is: Are these high-leverage stock option grants a "no-lose" add-on for CEOs, or are Compensation Committees shifting the pay mix from cash to stock?

To help answer the question, we focused on 199 companies in our survey with the same CEO in 1995 and 1996. At those firms, the median CEO salary increase was 5.3 percent - above the national average of about 4 percent, but not dramatically so. Twenty-four percent of the CEOs received no increases or lower salaries, either due to sub-par performance, longer intervals between salary reviews, or an exchange of salary dollars for increased bonus and option opportunities.

We also studied the 89 CEOs (from the group of 199) who had a 1996 Leverage Index of at least 3.00. Their 1996 total cash packages increased by a median rate of 4.3 percent, compared to 9.0 percent for the larger group. And 34 percent of them received the same or smaller cash packages as 1995, compared to 30 percent for the larger group of 199 CEOs. Given the emphasis on stock options in the 89 CEOs' pay packages, these statistics indicate that many Compensation Committees are increasing both opportunity and risk for the CEO, by transferring compensation dollars from salary or bonus to options.

Our Capitalization Index analysis provides further evidence that most CEOs have committed the bulk of their personal wealth to their company's fortunes - and the commitment has strengthened substantially in recent years. Capitalization Index measures the sensitivity of the CEO's pay plus total stockholdings to changes in company stock price. Again, a doubling of stock price results in a doubling of company-related wealth. If a Compensation Committee is serious about aligning the CEO's personal fortune to company performance, it should approve CEO compensation and ownership programs that create a Capitalization Index of at least 10.00.

LEVERAGE INDEX

INDEX                         1996         1995
2.00 AND ABOVE                 154         133
1.75 TO 2.00                     9          22
1.50 TO 1.75                    13          20
1.25 TO 1.50                    12          11
1.00 TO 1.25                    31          33

TOTAL                          219         219

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

INDEX                         1996         1995

20.00 AND ABOVE                 74           65
10.00 TO 20.00                  71           16
5.00 TO 10.00                   59           46
1.00 TO 5.00                    15           32

TOTAL                          219           219

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

Sixty-six percent of the companies in our survey - 145 of 219 - have CEO Capitalization Indices above the 10.00 standard, thus demonstrating the effectiveness of the last several years' emphasis on CEO ownership. This compares to just 52 percent of the surveyed companies two years ago. Only 12 percent of 1996's CEOs - many of them recent hires - have CEO Capitalization Indices below 5.00, down substantially from 19 percent in 1994 and 14 percent in 1995. By contrast, 34 percent of the CEOs in our study are over 20.00 in Capitalization Index - up from 22 percent in 1994 and 29 percent in 1995. For these CEOs, stock performance is 20 times more important than salary and bonus. Would shareholders want it any other way?

THE DISNEY STORY

How much pay is too much? We've all heard the arguments on both sides. Defenders of CEO pay largesse assert that any amount is reasonable, as long as it is tied to shareholder returns. Critics allege that pay levels become obscene at some (often undefined) level, thereby diverting resources from more worthy ends and contributing to the alienation of employees.

In our view, both arguments miss the point. Despite what the critics say, there is no CEO pay package that is by definition excessive - as long as the economics of the business can support it and the CEO's economic risk balances his opportunity. At the same time, though, a company's economic resources are inherently constrained, which means that an extra 100,000 options granted to the CEO might have helped create more shareholder value if they had been distributed elsewhere in the organization.

Executive compensation programs at the Wait Disney Co., have probably received more scrutiny over the years than any other company. And for good reason. Take a look at 1996, which illustrates both the healthy and unhealthy ends of the risk-reward spectrum. In 1996 CEO Michael D. Eisner negotiated a new employment agreement, calling for a $750,000 annual salary over the next 10 years, a new bonus plan based on earnings per share, and a grant of 8 million options. In addition, the company paid Michael Ovitz - who had been hired as president 10 months earlier - severance compensation of $38.8 million and let him keep 3 million options after terminating him for nonperformance.

Despite surface appearances each element of Eisner's agreement illustrates Disney's commitment to business economics and Eisner's willingness to accept risk in exchange for substantial opportunity. The $750,000 base salary is 21 percent below 1996 competitive practice and will fall further behind in future years. Clearly Eisner is willing to take some risk in terms [TABULAR DATA OMITTED] [TABULAR DATA OMITTED] [TABULAR DATA OMITTED] of salary in order to get a very significant financial opportunity based on performance.

Starting in 1999, Eisner will earn a percentage of company earnings in excess of 7.5 percent per year. While Eisner could earn eight-figure bonuses each year, the risks are enormous because the plan keeps raising the performance threshold every year.

Eisner also received a grant of 8 million options, which seems enormous even when spread over the 10 years of the agreement. Nonetheless, they are unusually risky due to such features as seven-to-10-year vesting periods and exercise prices as high as twice the stock price on the date of grant. To gain substantial value from these options, Eisner must commit himself to Disney for the rest of his career and generate substantial long-term shareholder value. Nor has the Compensation Committee neglected to share the wealth with other Disney employees: Eisner's 10-year grant represents only 26 percent of approximately 30 million options granted in 1996 to all employees.

While Eisner's deal exemplifies a healthy risk-reward balance, Ovitz's $38 million severance package symbolizes huge rewards without any risk. One can argue it was necessary in order to induce him to join the company. Nevertheless, what consequences (other than embarrassment) did Eisner and the board suffer from their hiring mistake? And shouldn't the board have been wary of Ovitz when he refused to accept the same degree of risk as Eisner?

RISK AND REWARD

While Disney provides the year's most dramatic examples of risk and reward - both positive and negative - there are many others. One positive example is Miami-based Knight-Ridder and its new Long-Term Incentive Plan. To earn a payout under the three-year plan, Chairman and CEO P. Anthony Ridder must outperform at least half of his peer companies and achieve a positive three-year total return to shareholders. Camden NJ-based Campbell Soup Company also builds peer group comparisons into the performance measures for CEO David W. Johnson's annual incentive plan and Restricted Stock Performance Plan. Both companies thereby avoid the riskless-ness of the "rising tide" factor, where a strong economy and stock market boost a company's absolute performance even when it underperforms the rest of the industry.

Both companies also illustrate the growing willingness of Compensation Committees to share the wealth with a broad group of employees who can create significant value for shareholders. Both CEOs received substantial option grants in 1996 - 220,000 options for Johnson and 70,000 for Ridder but they represented only 7.0 percent and 5.3 percent of the total options awarded to employees. By sharing the option wealth, both CEOs understand that they motivate broad-based performance, foster commitment to the long-term objectives of the company, and eliminate internal dissension between executives and employees.

Knight-Ridder and Campbell Soup are just the tip of the iceberg when it comes to granting options below the levels of CEO and the other officers named in the proxy statement. Many other companies share the option wealth, including such longterm performance leaders as Johnson & Johnson (99 percent of options to other employees), Intel Corp. (99 percent), Pfizer (97 percent), Hewlett-Packard (96 percent), Motorola (96 percent), and Citicorp (94 percent).

Yet some companies still don't get it when it comes to balancing risk and reward in CEO compensation or sharing the option wealth. Fifty-one companies in the survey granted at least 30 percent of their options to the CEO and other named officers - hardly a prescription for encouraging employee commitment. And Disney wasn't the only example of severance compensation gone wild. AST Research of Irvine, CA, paid CEO Ian Diery $2.1 million in severance, although he had held the position for less than 10 months. International Multifoods of Minneapolis agreed to pay its terminated CEO, Anthony Luiso, $1.1 million in severance compensation, accelerate the vesting of his options, and extend their exercise period (presumably to give them time to become in-the-money).

PEOPLE, PAY, AND PERFORMANCE

In the 1980s, the standard question Compensation Committees asked was: How does our CEO's compensation package compare to competitive pay levels? As we moved into the 1990s, the catchphrase became "pay for performance," as boards endeavored to ensure that CEO pay was strongly aligned with shareholder returns. As the excesses of both these approaches become clear, progressive Compensation Committees are now focusing on two critical questions. First, does the CEO's pay provide the right balance between risk and opportunity? Second, is the board putting options and other equity based pay instruments in the hands of all the employees who can create shareholder value, regardless of their spot in the organizational hierarchy? As we continue moving toward a knowledge-based economy, where the quality of its people is a company's greatest source of competitive advantage, the high-performing companies will be those that answer both questions affirmatively.

RELATED ARTICLE: METHODOLOGY AND TERMS

CEO pay data for the most recent fiscal year were analyzed from annual reports and proxy statements for o sample of 219 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 who has held office the longest during the company's fiscal year.

Company Performance equals annualized total return to shareholders for the 1993 to 1996 period. (As a simplifying assumption, dividends ore 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 on 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 overage vesting period to reflect forfeiture risk. If the proxy statement does not disclose vesting, we assume on average vesting of three years.

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

* Performance units and performance shores ore valued at target, discounted to reflect forfeiture risk like restricted shares. 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 stock-price growth rate, and Actual Pay assuming a 0 percent annual stock-price growth rate.

CEO Capitalization Index is o 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.

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Jack L. Lederer is principal and national practice leader, compensation, and Carl R. Weinberg is principal at Coopers & Lybrand Human Resource Advisory Group.