The long and winding road.

That's the direction executive compensation is taking, as companies tighten up the links between long-term profitability and their executives' net worth. Find out how they're driving the message home with new variations on the old stock-option carrot.

Hitched your star to your company's wagon? You'd better be prepared for the long haul. Today, executive-compensation programs primarily emphasize long-term incentive programs - and that's probably where the focus should have been all along. Annual-bonus plans have been almost universal since the late 1980s, but while the average bonus levels have increased, most of the increase stems from higher profitability, not changes to the bonus plans themselves. This signifies that in the future, your compensation will probably be tied even more closely to the company's overall profitability and the shareholder value you contribute.

In general, executive pay is a function of company size. The average salary and total cash compensation (salary and bonus) for executives in industry usually depend on company revenues, and the same is true in banking and insurance. For example, CFOs in companies with revenues under $200 million earn an average base salary of $140,000, while those in companies with $200 million to $500 million receive an average of $156,700, according to our latest executive-compensation survey. CFOs working for companies with $500 million to $1 billion in revenues receive an average of $211,100. And CFOs in companies with more than $3 billion in annual revenues earn average base salaries of $313,500, more than double their compatriots in smaller companies. Pay should correlate with size, of course, since fewer executives are experienced at running a $10-billion company than a $10-million company. As long as we have a free market, the rarer gem will command the higher price.

Overall, executive salaries haven't been rising rapidly, headlines in recent years notwithstanding. Between 1989 and 1994, CFO salaries rose more than financial-executive salaries in other categories - by about 4.7 percent. The average salary for a treasurer and a controller rose by approximately 4.2 percent and 4.5 percent, respectively, while the average salary for a CEO increased by about 3.6 percent per year.

The average salary increase by position is less than the average salary increase budgeted for executives, which was just over 5 percent during this five-year period. One reason for the differential is that companies often replace executives who retire or leave with lower-paid executives, a phenomenon often called "turnover savings." So a company that budgets an overall salary increase of 3 percent may be able to actually give its executives 5 percent, depending on the turnover rate.

Like salaries, bonuses also vary with the size of the company. Larger companies tend to pay larger bonuses, both in dollars and as a percentage of salary, than smaller companies do. The average bonus for CEOs in companies with less than $200 million in revenues is approximately 55 percent of salary, compared to more than 80 percent in companies with more than $3 billion in revenues. For CFOs at those companies, the numbers are 40 percent and more than 60 percent of salary, respectively. Average bonuses for CEOs have increased during the last five years by about 23 percent (or slightly more than 4.2 percent annually), while average bonuses for CFOs during the same time period increased by about 12.4 percent (2.4 percent annually).

In recent years, both the Securities and Exchange Commission pay-disclosure rules and tax laws have been modified in an effort to more strongly emphasize the pay-performance linkage. This isn't a new concept, of course. Our American sense of fairness has always demanded that pay relate to performance. Many studies have addressed this issue with embarrassingly few indicating a close connection.

While better-performing companies often pay higher bonuses than lower-performing companies, in far too many cases they don't. However, it's exceedingly difficult to establish the exact correlation of pay and performance in the short term, since individual company goals and strategies vary widely. Virtually every company defines and measures "performance" differently.

Measuring company performance is less difficult over the longer term, especially from the shareholder viewpoint. Stock price is clearly the single most important long-term performance measure for shareholders, especially considering that institutions and pension funds own approximately half the shares in public companies, and the company's performance is measured quarterly, if not more often. More recently, the SEC has mandated showing total shareholder return (stock-price appreciation plus total dividends reinvested) in annual proxy statements, and this has become the de facto measure of long-term performance for shareholders during the last three years.

HITTING THE STOCK-OPTION BULL'S EYE

Company Targets for performance-contingent stock options

Alco Standard   Long-term incentive-plan options may be exer-
                cised only with option credits, which are earned
                over a three-year period and which depend on
                the company's total shareholder return relative
                to the S&P 500 total shareholder return.

Charter         Options vest 20 percent for each fiscal year in
Medical         which the company achieves 100 percent of
                cumulative target earnings (before interest
                depreciation and taxes).

Citicorp        Options granted at $31.75 per share vest 50 per-
                cent when stock reaches $50 per share; 75 per-
                cent when stock reaches $55 per share and 100
                percent when stock reaches $60 per share (and
                sustains each target level for 20 out of 30 consec-
                utive trading days).

Consolidated    Options granted in 1989 and 1991 vest on the
Papers          company's achievement of net-income targets.
                The company met the goal in 1989, and the
                options vested. It didn't meet the goal in 1991,
                and the options lapsed.

Digital         Options vest 20 percent per year but may not be
Equipment       exercised unless the corporation's stock price
                averages at least $100 over 90 consecutive trad-
                ing days.

Eagle-Picher    Options aren't exercisable unless the market
                price per share is at least 20 percent greater than
                the option price per share.

Newmont         Options aren't exercisable unless on the day
Mining          before exercise, the market price per share is at
                least 25 percent greater than the option price per
                share.

Sysco           Options aren't exercisable unless the company
                attains certain levels of increases in pre-tax earn-
                ings and return on shareholders' equity. If not
                attained within five years, the options expire,
                even though their term is 10 years.

Source: William M. Mercer Inc.

NEW STOCK ANSWERS

Companies are following this trend, too. About 30 percent of major companies with performance-share plans now use total shareholder return as an executive-performance measure, and this proportion will probably increase significantly in the future. Equally important, companies are introducing performance requirements into a wide range of stock plans that previously reflected stock-price growth only, creating new incentive variations.

Performance-accelerated options are one popular vehicle. Essentially, the executive receives options that will eventually vest according to a schedule, regardless of company performance. However, the vesting accelerates if the company meets certain long-term goals. For example, Avery Dennison's options vest nine years and nine months after the grant date, but they can vest as early as three years from the grant date if the company achieves specified objectives, such as increasing its return on total capital. Other companies using the performance-accelerated option approach include ITT, Mellon Bank, Monsanto, Texas Instruments, Times Mirror and Toys "R" Us.

This approach has two advantages. First, the company generally grants options at the current market price, providing the executive the benefit of future appreciation. The option-exercise price is higher for premium or indexed options. Plus, current accounting rules don't require a charge to earnings, although the Financial Accounting Standards Board intends to require at least a footnote disclosure of the hypothetical option expense in the future for all types of options.

Performance-contingent options are quite different: They may never become exercisable unless the company achieves certain goals. For example, options granted to Citicorp executives in 1993 at $31.75 per share become exercisable based on stock-price appreciation. Fifty percent of the option becomes exercisable when the stock reaches $50 per share, 75 percent when it reaches $55 per share and 100 percent when it climbs to $60 per share. In each case, the stock must sustain the target levels for 20 out of 30 consecutive trading days. Other companies with performance-contingent stock options are Alco Standard, Charter Medical, Consolidated Papers, Digital Equipment, Eagle-Picher, Newmont Mining and Sysco (see table on page 37).

A company using performance-contingent stock options generally must report as an expense the difference between the exercise price and the stock value on the date the contingency is satisfied. Also, since performance-contingent options may never vest, companies often grant them on a much larger number of shares than they do with regular options, and this practice can rapidly use up the available pool of reserved shares. In the future, therefore, companies may favor performance-accelerated options, which are a good way to add a performance feature to a stock-option program without an earnings charge.

Another popular compensation vehicle is the performance-accelerated restricted stock grant, which rewards long-term performance through the acceleration feature. This differs markedly from traditional and widely used restricted-stock grants, which normally vest automatically when the executive continues to work for the company. Performance-accelerated restricted stock grants will eventually vest after a certain time period, but vesting may accelerate if the company attains its performance goals. The Allen Group, Avon, Clorox and Honeywell all have made performance-accelerated grants.

Other companies have emphasized making the eventual vesting of restricted stock contingent on the company's achieving predetermined objectives. These performance-contingent grants are essentially performance shares (a long-term incentive companies have used for more than 20 years) granted in the form of restricted stock. Companies granting such awards in recent years include Ameritech, General Dynamics and Melville. Performance-contingent restricted stock is likely to become an increasingly popular form of compensation, since "regular" time-lapse restricted stock grants won't qualify as performance-based compensation for tax deductibility under the $1-million pay cap that Internal Revenue Code Section 162 (m) imposes.

BEWARE OF STICKER SHOCK

Some critics of executive pay have objected to companies granting 10-year options at the current market price, since the long-term upward trend in the market and the economy will almost certainly make the options profitable, regardless of company performance. In response, some high-profile companies have granted "premium" options, including AT&T, Colgate-Palmolive, Walt Disney, Dow Jones, Philip Morris, Procter & Gamble, Quaker Oats, Reebok, Rockwell and Time Warner.

These options differ from performance-contingent options in that executives must pay an exercise price for their premium options that's substantially higher than the current market price at the grant date. AT&T, for example, has granted options in four tiers: 25 percent at fair market value, 25 percent at a price 120 percent of fair market value, 25 percent at 130 percent and the final 25 percent at 150 percent of fair market value. This approach is much less beneficial for executives than performance-accelerated or even performance-contingent options. Under either of those approaches, the executive gets the benefit of future appreciation after the grant date. With premium options, the executive gets only the benefit of appreciation over the higher, future target price. As a result, companies tend to grant premium options, like performance-contingent options, on a much higher number of shares than normal options.

On another front, the new SEC proxy disclosure rules have made three valuable contributions to evaluating executive pay over the long term: the focus on total shareholder return mentioned earlier, the requirement to include three years of pay history and, perhaps most important, the requirement that long-term performance be viewed on a relative basis over five years. The proxy rules for the last three years have required a graph showing the company's total shareholder return during the last five years in relation to both the S&P 500 (or another broad market index) and either a predetermined published industry index or a special peer or market-capital group of comparable companies selected by the company.

By requiring company total shareholder return to be compared with a broad market index and an industry index, the SEC has firmly (and, we think, appropriately) established relative performance as a comparison standard in evaluating executive compensation over the long term.

A large and growing number of companies use some form of peer-group measurement in their long-term incentive plans. More than 40 percent of large companies use it to determine long-term payout in their performance-share plans, and we expect that number to rise to more than 50 percent in the next several years.

Companies are also using relative performance in stock-option plans, in the form of indexed options. Such options have an exercise price that periodically adjusts in relation to market, industry or peer-group performance. For instance, in 1993 Dresser Industries granted options that stipulated the option-exercise price will increase in line with 30-year treasury-bond yields, less dividends paid. This assures executives benefit only beyond the "risk free" level of total return the company generates. Warner-Lambert indexed half of its 1992 option grants for senior executives to the S&P 500 for the first four years after the grant. The company must outperform the S&P 500 for these options to have any value for the first four years a very demanding hurdle for most companies.

CONSIDER YOUR STOCK OPTIONS

Median face value (exercise cost) of options granted annually as a %
of salary

Salary level(*)                 %

$600,000                        207
350,000                         164
250,000                         123
200,000                         119
150,000                          82
125,000                          65
100,000                          55
80,000                           37
60,000                           33
50,200                           24

* Executives in general industry

Source: William M. Mercer Inc.
WHAT'S IT WORTH TO YOU?

Market value of senior executives' stock (100 largest U.S.
industrial companies)

                    Shares owned         Shares owned
                 (without options)      (with options)

Percentile(*)      CEO      CFO         CEO       CFO

75th              $13.0    $2.3         $35.9     %6.0
50th                5.4     1.0          16.5      2.7
25th                2.1     0.5           9.9      1.4

Value of shares owned as a multiple of salary

                    Shares owned          Shares owned
                  (without options)      (with options)

Percentile(*)   CEO              CFO      CEO     CFO

75th            16.7 x salary    5.9      41.6    14.5
50th             6.6             2.7      21.7     8.4
25th             3.5             1.0      13.0     4.2

* At the 75th-percentile mark, 25 companies reported higher values
(not shown). The 50th percentile is the median. At the
25th-percentile mark, 25 companies reported lower values
(not shown).

Source: William M. Mercer Inc.

The relative-performance concept is useful in evaluating long-term company and executive performance. Most companies with long-term performance plans will probably use earnings or total-shareholder-return measures relative to peer-group averages within the next several years.

By offering stock options, companies clearly are providing executives with opportunities for significant gains. Many executives receive annual stock options worth more than their salary, as shown in the table on page 39. If the stock doubles in a year, many of these executives can exercise their options and realize a profit equal to their salary or more in just one year.

In most cases, companies that emphasize long-term programs give their executives enough interest in company stock growth so that their net worth will largely depend on long-term company performance. This is especially true in smaller entrepreneurial companies that don't provide pension plans but that do provide their executives with opportunities for regular stock acquisition through stock-purchase and 401 (k) plans. In more and more cases, these companies are tying executive wealth to long-term total shareholder return.

KEEP IT IN THE FAMILY

Plus, companies are encouraging their executives to acquire and hold stock. That's often at the behest of a board of directors frustrated with traditional stock-option plans because so many executives exercise their options and promptly sell the stock. Approximately a quarter of the largest companies have adopted new executive stock-ownership guidelines, usually stated as a multiple of salary. Typical multiples are: CEO, four to seven times salary; COO, three to four; executive vice president, two to three; CFO, one to three; other officers, one to two; and other executives, one.

In fact, the increased emphasis on stock ownership is producing results. A recent analysis of stock ownership among CEOs of the 100 largest industrial companies indicates these executives do, in fact, own substantial amounts of their company's stock (see chart).

In any case, the message to financial executives is clear: Put shareholder interests first, and take the long view. If the stock appreciates, for whatever reason, you'll feel it in your wallet.

Mr. McMillan is managing director at the Houston office of William M. Mercer Inc. Mr. Sabow is manager of the executive-compensation research group at Mercer's New York office.