Pay under pressure: in a down market, the spotlight always shines on CEO compensation. But will the scrutiny actually drive change this time--or is this yet another passing storm? (Compensation).

The outrage was impossible to miss. "We are appalled and just disgusted," said John Ward, president of the Association of Professional Flight Attendants, at an April 17 press conference. "It's the equivalent of an obscene gesture from management." Ward was referring to the discovery that while American Airlines was asking its employees for a massive pay cut to avoid bankruptcy, it hadn't disclosed that top executives were being paid up to twice their base salary in retention bonuses and having their own pensions put in a bankruptcy-protected trust. Chastened, Donald Carty, CEO of American's parent company AMR, agreed to drop the bonuses, but the damage was done, and he later was forced to resign.

Time was when Carty and his colleagues in the corner office could do no wrong, when the admittedly sky-high compensation of the CEO was seen as just reward for an equally high return to shareholders. But now, a litany of financial scandals and a sagging stock market have punctured CEOs' once-unassailable armor, changing their image from a group of brilliant leaders to a class of plundering plutocrats. As inaccurate as both extremes may be, the perception pendulum has swung hard and fast. CEOs are now cast as villains, not heroes. To wit, a CNN/USA Today/Gallup Poll in 2002 ranked CEOs of large corporations just above car dealers in trustworthiness, with 73 percent of respondents agreeing that you "can't be too careful with them."

All of this mistrust means that the system by which executives are paid is coming under extreme scrutiny. Once monitored by a small group of hard-core activists, today shareholders, directors, journalists and legislators are deeply focused on how much CEOs are paid--and whether they deserve it. Although the attention to executive pay has traditionally waxed and waned according to the economic cycle, this time people are wondering whether the process itself is broken. "The stock market bubble has burst, the economy is in recession, and there are a number of layoffs and restructuring," says James Rogers, CEO of Cincinnati energy company Cinergy. "As a consequence, there is greater emphasis on the disparity in earnings [between workers and executives]. For CEOs, the pressure is greater than it's ever been."

To each their own numbers

The pressure may be greater, but what a bout the money itself? Despite a huge amount of publicly available information on the subject, it's hard to find any consensus on whether pay is up, down or sideways overall. There are a wide variety of different methods by which annual compensation is measured, and each publication that covers the issue, eager to stake out its own turf, jumps to a different conclusion. Says Judith Fischer, managing director of ECAS, a unit of Towers Perrin: "[The level of] executive compensation is in the eye of the beholder."

According to BusinessWeek, which counts salary, bonus, exercised options, restricted shares and long-term incentive payments, but not the value of unexercised options, total average pay for 365 executives of the largest public companies fell by 33 percent to an average take of $7.4 million. It was the second double-digit decline in a row. Yet Fortune, which featured an oinking pig in a suit on its cover, looked at the median pay for 100 large public companies and drew the opposite conclusion--that pay actually rose 14 percent in a year of economic devastation. It is worth noting that Equilar, which compiled the Fortune research, published results from its own broader study of 473 S&P 500 companies, and found total compensation had fallen by 10 percent.

The Wall Street Journal had median numbers similar to Fortune's, but took the perspective that the tide has turned, and executives will soon be getting a dose of much needed fiscal discipline. Towers Perrin offered up evidence that salaries and bonuses of those who had been CEOs in both 2001 and 2002 were up 6 percent and 10 percent, respectively--but interpreted it as a sign of moderation because the percentages were lower.

On the individual level, there are certainly high-profile cases of abuse. The press happily hoisted executives such as Tenet Healthcare's Jeffrey Barbakow--who exercised stock options worth $111 million in a year when the company was being investigated for Medicare abuse--upon their own petards. Still other CEOs, such as Tyco's Dennis Kozlowski and HealthSouth's Richard Scrushy, cashed in consistently over the past few years--and then found themselves under criminal indictment.

Combined with the loss of thousands of jobs, it made for ugly, often embarrassing reading. A study released last year by United for a Fair Economy showed that CEOs involved accounting or financial scandals had earned 70 percent more than CEOs of other companies between 1999 and 2001, while their companies' shares lost 73 percent of their value. "It's not healthy if the world out there thinks that CEOs and top people are getting outrageous compensation compared to the workers," says Corning Chairman and CEO James R. Houghton.

Whatever the perception, one thing is dear: There are major changes afoot in the way executives are paid. "Compensation committees are going to be much more intense about reviewing pay-for-performance-based systems," says Larry Hirsch, chairman and CEO of Centrex.

Start with the fact that the main instrument of pay over the past few years--the stock option--has ceased its upward trajectory, at least for now. For most of the bull market, options were viewed as an easy way to link the shareholder to the executive. If the stock went up, everyone won. If it fell, the executive's options were worthless. "Some executives thought that options could bring world peace and solve cancer," quips Paula Todd, a principal at Towers Perrin. Yet despite better corporate governance and more involved boards, the sheer numbers of option grants still allowed many heads of slumping companies to take home hundreds of millions--while others who managed to outperform their competitors found themselves with worthless packages.

Now, with the S&P 500 dropping 13 percent in 2001 and another 23 percent in 2002, many options granted in prior years are entirely underwater, and unlikely to surface soon. Because options make up as much as two-thirds of the value of total compensation packages, this fact alone has reduced CEO pay considerably. And while plenty of boards are still happy to grant piles of options at a much lower price, Todd says the actual number of shares granted hasn't risen--so the value of option grants has dropped in this terrible market.

There was another clear reason for options' popularity: They were not counted on a company's income statement as a compensation expense. Yet they did have a major cost. They diluted the value of existing shareholders' shares, causing a hangover that has now made it impossible for some smaller companies to grant any new shares even if they wanted to.

With so many options floating around, boards lost control and relied on "competitive data" to determine who made what. Says Brian Hall, professor of business administration at Harvard Business School: "If you're going to put that much fuel in the rocket, you better make sure your internal controls are sufficient to withstand that pressure so you don't have explosions." But the controls weren't good enough. And the ensuing scandals at traditionally high-paying, options-oriented companies such as Enron, WorldCom, Tyco and others left many people convinced that there was a linkage between outsize compensation and cooking the books.

That's why board compensation committees--and some CEOs as well--are now trying to limit the damage. More than 200 companies have volunteered to account for options on their income statements, and the Financial Accounting Standards Board is planning to take up the issue later this year. If it becomes mandatory, it would mean a major hit to earnings for heavy users, primarily technology companies, and a change in their appeal relative to other types of pay. Says Hirsch, whose company began expensing options in April: "Once you expense the option and it can be compared to other forms of long-term compensation, we'll see some rational decisions about pay."

A harsh take on options

Some people have even gone so far as to question whether stock options are an effective motivational tool for top executives. "Options are terribly capricious," says John Biggs, former CEO of giant pension fund TIAA-CREF, and a director at Boeing and JP Morgan Chase. Biggs sees three major downsides to options, starting with the fact that they focus attention more on the day-to-day fluctuations of the stock than on the long-term running of the business. "They create an obsessive interest in the current price," he says. Biggs also believes that options don't increase long-term stock ownership, a critical objective for CEOs, and that they encourage executives to leverage their company and not pay dividends, which can be as harmful for investors as the obvious hit to the stock price.

As a replacement--or, in some cases, an add-on--many companies are turning to grants of restricted stock. Unlike options, which have value only when the stock price rises, restricted stock is always worth something, even if it falls by 99 percent. Like options, it must be held for a period of time, often at least five years. The idea is to provide an incentive that isn't quite as arbitrary as options seem to be--and also, say some critics, to find a way to pay executives in a flat market. "There s definitely been a shift from options to restricted stock," says Don Delves, president of Chicago pay consultancy The Delves Group. "But if it's just a straight shift from plain vanilla options to plain vanilla restricted stock, you've gone from a gamble to a guarantee, and that accomplishes nothing."

At Exxon Mobil, the compensation committee decided not to award any stock options to CEO Lee Raymond in 2002, instead granting him $17 million in restricted stock. According to the proxy: "The Committee concluded that, at this time, in this industry, and in this Company, restricted stock is more effective in aligning executives' interests with those of shareholders and in achieving the objective of retention." And at Apple Computer, the board allowed founder and CEO Steve Jobs to turn in his 27.5 million underwater options-which he accepted with great fanfare, instead of salary or bonus-for 5 million shares of restricted stock, which at the time were worth $72 million. Apple's share price had plummeted, sending an odd message.

Yet some boards have decided to give restricted stock more teeth, either by attaching performance conditions or by forbidding executives from selling it for their entire tenure at the company. That's the situation at Cinergy, where as of 2002, CEO Rogers and his top team must hold any exercised options and restricted stock until 90 days after they leave the company or retire. "That's the long, long, long term," says Rogers. "I'm 55. If I stay until I'm 65, I have to make decisions that are good decisions, that create lasting value."

Wherever executives come off on the pay scale, they are now being monitored more publicly on not only their salaries and bonuses, but also their perks, retirement packages and retention bonuses. At Hewlett-Packard, shareholders approved a non-binding proposal that would require directors to get investor approval for any executive severance package worth more than three times salary and bonus. It seemed a pointed rebuke to the company, coming on the heels of the $14.4 million severance package of Michael Capellas, the former CEO of Compaq who merged with HP. Carly Fiorina, HP'S CEO, had argued that such packages were necessary to recruit the best executives, but Capellas seemed to have little trouble-he went on to take the reins at WorldCom, where he was guaranteed $3 million in salary and bonus simply for taking the job and will be eligible for an additional $18 million m restricted stock once the company emerges from bankruptcy "I was particularly unimpressed" with both deals, says Paul Hodgson, senior rese arch associate at The Corporate Library a governance research organization based in Portland, Maine.

Such golden hellos and parachutes are difficult to justify when regular workers' job security is virtually nonexistent--a lesson AMR's Carty learned. Experts say what ultimately will restore the reputations of CEOs and faith in the markets is a system in which good guys can prosper while others feel financial pain. "The best compensation system serves its objectives irrespective of whether the stock market has been mean to us," says Dan Ryterband, managing director at pay consultancy Frederic W Cook & Co. To him, that means a carefully measured combination of stock options, cash and restricted stock, tied closely to company performance.

Less pay, more pressure, bad press, higher penalties for messing up. Will some CEOs simply throw in the towel, creating a talent vacuum in the executive suite? No way, says Ryterband. "That is such utter B.S.," he says. "I spend my whole life talking to CEOs and that is not what's happening. Being the CEO of a major publicly-traded company is about a lot more than dollars and cents. It's about power and the ability to impact things like society and their communities."

It does appear that short-term pay may decline along with options values. But it won't be known for some time whether the current hunger for a system in which pay is more closely tied to performance will be forgotten once the stock market rises. Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, is hopeful that tougher compensation committees combined with the Sarbanes-Oxley Act will help, but cautions that it will take many years for a new, more watchful mentality to take hold. "Pay is not back in control and will not be back in control until boards change," he says, "not until independent directors with a lot of skin in the game dominate the board."

A look back through the archives shows that over time, executive pay has only moved in one direction-up. But if reform measures actually stick, there is a chance that it will be only those honest, value-creating executives who will cash in at the end of the day.

While Cash Compensation is Beginning to Rise Again ...

Median Salary and Bonus

$ MILLION

2000  1.8
2001  1.6
2002  1.8

Note: Table made from bar graph

...the Declining Value of Options

$ MILLIONS

      Median Value of Stock  Median Gains on Option

         Options Granted *         Exercises
2000           3.1                    1.9
2001           4.3                    2.1
2002           3.8                    1.7

Note: Table made from bar graph

...Means Smaller CEO Paychecks Across the Board

Median Expected Total Direct Compensation **

$ MILLIONS

2000  5.2
2001  7.0
2002  6.1

* Option values are calculated using a binomial option-pricing model
with the following inputs: stock pirce at grant date; exercise price of
ption; term of option; risk-free rate of return at grant date, which
represents the yield on US Treasury Strips with a maturity date
corresponding to the term of the option; expected dividend yield
calculated using the annual dividend rate in effect atgrant date; and
expected volatility, calculated using monthly closing stock prices over
36 trading months prior to grant date.

* Expected total direct compensation - base salry, annual bonus, the
binomial value of stock options, restricted stock, and other target
long-term incentives

Source: Mercer Human Resource Consulting survey of 350 public companies

Note: Table made from bar graph

RELATED ARTICLE: Eye of the Beholder

HIGHLIGHTING THE COMPLEXITY of evaluating CEO compensation, three business publications studied the numbers and each came to a different conclusion.

* BusinessWeek counts salary, bonus, exercised options, restricted shares and long-term incentive payments, but not the value of unexercised options. It does its own analysis and highlights the average compensation of 360 large company CEOs. The result: Pay dropped 33%

* Fortune, working with Equilar, counts salary, bonus, long-term incentive payments, restricted stock and the present value of stock options using the Black-Scholes method, but not previously granted options exercised in 2002. It focuses on median numbers for 100 large company CEOs. The result: Pay rose 15%

* The Wall Street journal, working with Mercer Human Resource Consulting, includes salary, bonus, long-term incentives, restricted stock and options exercises, using the median of 350 large company CEOs as its benchmark. The result: Pay rose 15%