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Exploding myths of CEO pay.

It's time to set the facts straight about CEO pay. CE's sixth annual compensation survey shows that the relationship between pay and company performance is solid, and far from being an unconditional windfall, most option grants ratchet up risk and further tighten pay leverage.

We never understood how defensive some CEOs had become about their pay, until one CEO in our survey insisted that we exclude his alimony payments. (We didn't.)

Of course, CEO defensiveness about compensation should surprise no one. The press, politicians, and pundits have pounded the public with hostile messages that CEOs are drastically overpaid, and that their pay bears no relationship to company performance.

Yes, there are examples of CEO pay abuse. However, our research for this, our sixth annual survey for Chief Executive on CEO pay, refutes the prevailing pontifications, showing that CEOs are paid fairly relative to other workers, that the alignment of CEO pay and company performance is strong and growing, and that the CEO labor market is healthy, efficient, and about as risky as that of the general public.

It's time to set the facts straight about CEO pay. In this article, we explode seven popular myths:

* CEO pay bears no relationship to company performance.

* CEO pay packages have no downside risk.

* CEOs face no employment risk.

* CEOs earn 160 times more than the lowest-paid worker.

* Huge option gains unfairly reward CEOs.

* CEOs use legal mumbo jumbo in proxy statements to hide the truth about their pay.

* CEO pay excesses are sapping American competitiveness.

Myth No. 1: CEO pay bears no relationship to company performance.

This is the most insidious myth of all, because it implies a conspiracy of exploitation.

But examples of abuse notwithstanding, our data proves that at most of the companies in our study, pay and performance are linked and examples of high pay and low performance are rare. Of the 229 companies in our survey, 59 percent are examples of high total pay/high performance or low total pay/low performance. (In this analysis, "high pay" means 1991 pay was above the competitive level, adjusted for size and industry group. "High performance" means total return to shareholders for the 1988-1991 period exceeded the industry median.)

Only 17 percent of the companies fall into the reviled "high pay/low performance" category. And half of these are mitigated by the fact that the CEO is a recent hire and thus could not be held responsible for historic performance. One such example is William Anders of General Dynamics, a newly minted CEO whose shareholders enjoyed a 116.8 percent return in 1991. Anders inherited the legacy of General Dynamics' low performance: 4.3 percent annual total return over our measurement period versus the aerospace industry's median of 5.4 percent. Maybe that is why he got the job.

Our leverage index analysis also reveals the strong relationship between pay and performance. This benchmark measures the degree to which stock price increases will influence the value of the CEO's pay package after five years. If a doubling in the stock price over five years (i.e., 15 percent compound annual growth) will have no effect on the value of the pay package, then it has a 1.00 leverage index. If a doubling in stock price will double the pay, then the leverage index is 2.00, and so forth.

The median 1991 leverage index for the 229 companies in our survey was 1.64, up from 1.58 in 1990. Thus, in half the companies we studied, pay grows by at least 64 percent if the stock price doubles in five years. This demonstrates a strong linkage between CEO pay and company performance.

We will present additional evidence in future articles to refute the assertion that performance accounts for only 5 percent of the variance in chief executive pay. [TABULAR DATA OMITTED]

Of course, some CEO pay packages still defy explanation. Eli Lilly's shareholders deserve an explanation why CEO Richard Wood earned $2,217,900 in total cash and $8,549,600 in total pay--42 percent and 146 percent, respectively, above the competitive standards for the pharmaceutical industry--while Lilly's shareholders endured substandard returns. (These returns amounted to 16.7 percent in 1991 versus an industry median of 55.2 percent; 23.1 percent per year over four years compared to 31.2 percent for the industry.)

Myth No. 2: CEO pay packages have no downside risk.

"OK," conceded one prominent pay critic when faced with our leverage index data. "I agree that a rising stock price has a major impact on CEO pay. However, CEOs make a fortune if performance is high, but they don't lose when performance is poor."

The facts say otherwise. Total cash compensation for CEOs in our survey increased at a median rate of 3.5 percent over 1990--less than the average wage increase of 4 percent. Total performance pay grew 8 percent, reflecting today's emphasis on long-term incentives, which can be worth nothing if performance declines.

When we looked at specific industries, downside risk became even more obvious. CEOs in poorly performing industries suffered declines in median total cash compensation, for example, -2.6 percent in natural resources; -4.7 percent in publishing; -6 percent in industrial equipment; and -6.6 percent in automotive. Industries experiencing declines in total performance pay included automotive at -8.4 percent, industrial equipment at -1.5 percent, and publishing at -6.5 percent.

CEO total cash compensation declined at 82 of the total 229 companies in our survey; total performance pay decreased at 90 companies. This illustrates the downside risk in CEO pay packages.

Meanwhile, a growing number of progressive CEOs are using exchange options to increase their upside potential--and their downside risk. As we reported in "Bold Thinking In CEO Pay" (CE: January/February 1992), exchange options are fair-market-value options which executives "purchase" through salary and/or bonus reductions. CEOs in our survey who participate in exchange option programs (or a variant thereof) include Anthony Luiso of International Multifoods, H.B. Atwater of General Mills, and Raymond Vecci of Alaska Air.

Of course, some CEOs continue to place themselves above risk. Loral's employment agreement with Bernard Schwartz mandates minimum annual salary hikes equal to increases in the Consumer Price Index. (We wonder how Loral's management feels about mandatory COLAs for down-the-line workers.) Richard Lehmann's contract at Valley National guarantees a minimum annual incentive of one-third of base salary. (If it's guaranteed, where is the incentive?)

We also question the risk-reducing practice of granting restricted stock in lieu of stock options. Since 1987, CIGNA has granted only restricted stock to senior executives. In the most widely publicized example, Roberto Goizueta of Coca-Cola received 1,000,000 restricted shares with an underlying value of $80,250,000. Unlike options, restricted stock pays off big even if the stock goes nowhere. This reduces downside risk in the CEO's pay;
Index 1991 1990
Above 2.00 73 67
1.75 to 2.00 22 32
1.50 to 1.75 34 26
1.25 to 1.50 32 27
1.00 to 1.25 68 77
Total 229 229
Industry 1991 1990 Differential
 % % %
Aerospace 36 57 21
Automotive 54 46 8
Banking 87 67 20
Chemicals 69 50 19
Computers & Tech. 79 50 29
Electronics 50 63 -13
Financial Svcs. 50 42 8
Food & Beverage 67 67 0
Industrial Eqpt. 67 33 33
Oil & Gas 50 63 -13
Pharmaceuticals 54 54 0
Pub. & Broadcasting 44 67 -22
Retailing 69 63 6
Transportation 64 86 -21
Utilities 44 38 6
Overall 59 57 2


Myth No. 3: CEOs face no employment risk.

"OK," CEO pay critics concede, "at lots of companies CEO pay rises or falls according to performance. But CEOs still don't have the same risks their employees do--they don't have to worry about getting fired."

Again, the facts say otherwise. Although it is not always clear whether a termination was truly voluntary or not, we estimate that 28.4 percent of the companies in our survey involuntarily terminated a CEO during the 1987-1991 period. In other words, on an annualized basis, CEOs in our study about a 5.7 percent chance of losing their jobs--somewhat lower than the national rate of 8.7 percent, but a significant risk nonetheless. And it takes fired CEOs at least a year or two to find a comparable new job--if they ever do--which is a lot longer than the national median of six weeks.

Of course, we don't claim that average employees enjoy the same safety nets as fired CEOs. On the other hand, neither do we suggest that the average dismissed employee faces the same level of public embarrassment as his CEO counterpart.

Myth No. 4: CEOs earn 160 times more than the lowest-paid worker.

The press, politicians and retired consultants have had a field day reporting this alleged fact. It's certainly dramatic, but the numbers are skewed. According to our survey, CEOs earn 38.7 times more than the lowest-paid workers. The multiple climbs to 61.2 if the value of long-term awards is included.

From whence comes the multiple of 160? One popular "study" uses $3.2 million for CEO pay and $20,000 for the lowest-paid worker. Neither figure is accurate. The CEO pay number equals the median earnings for CEOs at the nation's 100 largest companies. Yet these companies employ less than 7 percent of the domestic work force. Thus, a CEO pay figure of $3.2 million is inaccurate.

In addition, the analysis in question has other flaws. Neither of its pay numbers includes the cost of benefits, both qualified and non-qualified. Organized labor's willingness to consider wage-benefit trade-offs implies that any thoughtful analysis should include both. (Labor representatives might also insist on adjusting CEO pay downward to reflect the extra hours the average executive works. In this case, the pay multiple could be as low as 20 or 30.)

Politicians may still contend that pay multiples as high as 40 or 60 are unconscionable and should be punished by the IRS code. But at least they should base their argument on accurate data. (By the way, if one includes benefits, per-quisites, honoraria, and campaign contributions, how much more does the average Congressman make than the lowest-paid campaign worker?)

Myth No. 5: Huge option gains unfairly reward CEOs.

Some deride gains that CEOs earn on stock options. Repeatedly, one sees references to examples, including Chrysler's Lee Iacocca, whose option gains during 14 years at Chrysler total $43 million, and Engelhard's Orin Smith, who reaped $3.7 million in option gains in 1991.

The critics conveniently ignore the risks CEOs assume by accepting pay packages that emphasize options instead of cash, as well as the value these CEOs have helped create for their shareholders. Iacocca is the most dramatic example. Everyone cheered when he volunteered for a $1 annual salary and the rest of his pay in options. But many cheerleaders chocked when his option gamble paid off.

Further, critics ignored that shareholder returns at Chrysler during Iacocca's tenure ran about 33 percent above the average Fortune 20 company. Similarly, Engelhard's four-year return to shareholders is 28 percent above the industry median.

Also noteworthy are CEOs who have embraced the concept of megagrants of premium-priced options, as we recommended in our January article. Examples include Stephen Wolf of UAL and Paul Fireman of Reebok. Under these programs, investors must earn a minimum return before the options are in the money. In return for this increased performance risk, the CEO receives an unusually high number of options. This ties more rewards to more risk--and greater shareholder gains. Such progressive compensation design is a radical departure from the thinking of CEOs like John Sculley of Apple, who in 1990 received re-set options, where underwater options were canceled and reissued at a lower market price.

Myth No. 6: CEOs use legal mumbo jumbo in proxy statements to hide the truth about their pay.

This assertion has some validity. Proxy-reading is still a numbing exercise. Nonetheless, even proxy statement obfuscation is receding. Although some companies like Gencorp, Time-Warner, and Capital Cities/ABC make key information incomprehensible, others use proxies as communication vehicles. American Express, Gannett, and Philadelphia Electric, for example, use their proxies to explain their executive compensation philosophies, while providing multiyear tables that allow for year-to-year pay comparisons.

Myth No. 7: CEO pay excesses are sapping American competitiveness.

This fantasy is the capstone myth, but quite to the contrary, we believe performance-driven pay packages are helping to spark the resurgence of American competitiveness and entrepreneurial verve. By the year 2000, economic historians will look back on pay philosophies that emphasize stock-based compensation, incentives, leverage and employment risk, as one of the competitive advantages the U.S. enjoyed during the 1990s over its rivals in Europe and the Far East. Our rivals in Europe are beginning to emulate America's use of incentives in pay practices. Will the Japanese be far behind?

American competitiveness stumbled badly during the 1970s and early 1980s. During that period, CEO pay packages were heavy with cash, perquisites, and rewards for company size. Today, CEO pay packages increasingly resemble the risk-laden pay arrangements for entrepreneurs. Potential payoffs to CEOs are larger than ever--and growing. But increasingly, significant shareholder gains are prerequisites to any compensation windfall.

As one example, consider the Big Three automakers. Ford's and Chrysler's boards have long believed in CEO pay leverage. (Their leverage indices in the 1980s averaged 2.30 and 3.07, respectively.) Not surprisingly, Ford and Chrysler have successfully begun to address critical strategic issues of quality, productivity, and product design. Meanwhile, despite Cadillac's Baldridge Award, General Motors remains a laggard in these areas. Over the same period, its leverage index was only 1.71. But in 1991, GM's index jumped to 3.75.

Is General Motors finally betting on a performance turnaround? That's the message we read in this long overdue measure of CEO confidence.

We have long contended that companies should design pay packages that motivate higher performance through the alignment of shareholder and corporate interests. We expect to see pay packages with higher leverage as shareholders, boards and executives continue to seek a competitive advantage in motivation and accountability.

In America, pay for performance is a positive and healthy value. Indeed, our survey reveals that an ever-increasing number of companies are getting it right.
COPYRIGHT 1992 Chief Executive Publishing
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:CEO Compensation; includes methodology and terms
Author:Meredith, David R.
Publication:Chief Executive (U.S.)
Date:Sep 1, 1992
Previous Article:1992 Chief Executive of the Year.
Next Article:Commerce's front-line cannon.

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