Printer Friendly

Hey, Bill: get out of the way on pay.

Each year we ask participants to verify pay and performance data we use in our survey. This year our favorite response came from a CEO who insisted we exclude his performance share grant because, "we never hit our performance targets." (We counted it, anyway.) Yes, some CEOs still don't want to use pay to hold themselves accountable for performance. But the 244 companies in our survey are doing an increasingly better job of linking CEO pay to performance.

Who deserves the credit? In our opinion CEOs share it with their compensation committees, institutional investors, and even the SEC. More CEOs and compensation committees than ever before are forcing pay to mirror performance. Institutional investors wisely are framing the debate by focusing on how pay is delivered rather than the populist obsession with absolute pay levels. And while we don't endorse every detail of the new SEC proxy rules, they help provide the sunshine of open and consistent disclosure.

But dark clouds loom on the horizon. Clinton, Congress, and the FASB are caught in a time warp, focusing on yesterday's issue of pay levels instead of today's issue of pay vehicles. As a result, they are advancing public policy proposals which would discourage pay-for-performance, distort the labor marketplace, discourage CEOs from owning stock in their companies, and--perhaps worst of all for the U.S. economy--move even more low- and middle-income jobs offshore or out of their companies entirely.


While more countries than ever before are endorsing our traditional economic system, our political and other public policy leaders are proposing legislation that will destroy the creativity, entrepreneurialism, and personal commitment upon which we have built the greatest job-creating and wealth-generating engine of all time. Now is not the time for the faint-hearted. We must unite public and corporate policy to encourage sustained CEO and executive ownership of their companies, stock.

In this, our seventh annual survey for Chief Executive, we will:

* Outline today's patterns in CEO pay and demonstrate how shareholder interests are met.

* Detail the hidden pitfalls in the most popular public policy proposals.

* Propose needed changes in the tax code to promote executive stock ownership.

1992 was a good year for those who believe in pay-for-performance and in aligning CEO and shareholder wealth. Total cash compensation for companies in our survey (excluding the 22 that replaced their CEOs during the year) increased 9.2 percent over 1991, consistent with their 7.3 percent increase in profits before FAS 106. Total performance pay, which includes the value of stock options and other forms of long-term compensation, grew 10.6 percent over 1991 levels, indicating the continued emphasis on long-term incentives that pay off only if performance improves. (Exhibit I compares 1991 and 1992 competitive compensation levels for each industry at $3 billion and $8 billion in revenues.)

Even more important are changes in pay leverage. Our leverage index measures the sensitivity of the pay package to a doubling in stock price over five years. A leverage index of 2.00 means the value of a CEO's total pay package doubles when the stock price doubles. An index of 1.50 means the total pay package increases 50 percent when the stock price doubles. And 1.00 means the value of the CEO's total pay package doesn't vary at all with stock price.

CEO pay packages are becoming linked more strongly to stock performance than ever before. The median leverage index in our survey grew from 1.65 to 1.81, the biggest increase in any single year so far. Meanwhile, the number of high-leverage companies (indices above 2.00) increased by 34 percent, while low-leverage companies (indices below 1.50) shrank by 10 percent. (See Exhibit II.)
INDEX 1992 1991
2.00 AND ABOVE 107 80
1.75 TO 2.00 19 24
1.50 TO 1.75 22 33
1.25 TO 1.50 21 34
1.00 TO 1.25 75 72
TOTAL 244 243(*)


As we studied individual industries, we saw numerous examples of strengthened bonds between CEO pay and shareholder performance. Among automotive companies, it looks like Ford and GM finally have caught on to the lesson of the Iacocca era--significant pay leverage encourages CEOs to make tough decisions that grow shareholder value. Both companies scored their highest CEO leverage indices in the 15 years we've been tracking them--8.01 for Ford (up from 3.44 in 1991) and 4.79 for GM (up from 3.75). Last year, we suggested that GM's new found commitment to leverage might be signaling a company resurgence. In 1992, its shareholder return reached 16.5 percent, a dramatic turnaround from 1991's 11.4 percent decline. It looks like the wake-up call has been heard.

Unfortunately, another company in the automotive industry still doesn't seem to get it. Given its eroding performance, it makes sense for Navistar CEO James C. Cotting to earn a base salary 22.5 percent below the industry and total cash compensation 47.4 percent below. But with a leverage index of 1.00 and a capitalization index of 3.19, growth in Navistar,.s .stock price has little impact on his wallet. Where's the motivation to work on behalf of shareholders?

Gadflies mistakenly look at total pay levels and miss the pay-for-performance linkage. Engelhard, the chemical company that has turned around its performance over the last two years, is a good example. A superficial analyst might conclude that CEO Orin R. Smith's $3.9 million pay package for 1992 is out of whack with competitive practice.

A closer study, however, shows how pay leverage motivates Smith and rewards the shareholders. Smith's 1992 salary of $620,000 is virtually identical to competitive industry practice of $614,000. His salary plus bonus of $1.3 million exceeds competitive practice by 38 percent--but that's a good deal for shareholders, given Engelhard's 1992 shareholder return of 61.3 percent (an outstanding follow-up to 1991's 76.1 percent), and far in excess of the industry median, 8.8 percent.

The total performance pay numbers sustain the view that Smith prosper by dint of performance on behalf of the shareholders. While his 1992 total performance pay of $3.9 million considerably exceeds competitive practice of $1.4 million, so do Engelhard's 1989-1992 shareholder returns (33.3 percent per year versus an industry median of 12.7 percent). How did Engelhard's shareholders make out? They paid Smith an extra 21 cents for every $100 in above-industry wealth they gained--yielding benefits all around.

Another chemical company, American Cyanamid, is the opposite of Engelhard in pay design and performance. In 1992, its CEO, George J. Sella Jr., received total cash compensation of $1.4 million, which exceeded the chemical industry's competitive practice by 36 percent.

The difference between the two companies lies in their performance. In 1992, American Cyanamid's shareholders lost 8.5 percent on their investment, while Engelhard's shareholders gained 61.3 percent. Nor does Sella's 1992 total performance pay appear to be related to performance. His total pay in 1992 equaled $2.2 million, or 32 percent above the; industry. This was despite a four-year performance of 7.9 percent per year, which fell 37.8 percent below the industry median of 12.7 percent.

In the technology arena, Xerox tightly links CEO pay with performance. CEO Paul A. Allaire's $700,000 salary is 31 percent below competitive practice for the computer and office technology industry. Through performance leverage, total cash compensation and total performance pay rise to competitive levels--but only as driven there by actual performance.

In the same industry, it's clear that Commodore doesn't follow Xerox's example. How does a compensation committee justify 1992 compensation for its CEO, Irving Gould? It didn't have to--Commodore's proxy statement came out in September, before the new SEC rules took effect. The $1.8 million Gould received was 112 percent greater than competitive total cash and 66 percent greater than competitive total pay. These pay levels contrast starkly with Commodore's 1992 shareholder performance of -55.5 percent and 1989-1992 performance of -15.5 percent per year.

Roy Vagelos of Merck & Co., 1992 Chief Executive CE of the Year, takes CEO-shareholder alignment an admirable step further. His 1992 total performance pay of $8.3 million looks excessive at first glance, compared to competitive pay for the pharmaceutical industry of $3.3 million. At least, that's what some hit-and-run CEO pay critics asserted before a Congressional Committee.

A closer look shows that over 40 percent of his 1992 pay comes from a special one-time grant of 500,000 stock options. Merck's proxy statement specifies that this grant replaces future option grants and salary increases. Thus, Vagelos--and Merck's compensation committee--have tied his future net worth to his effectiveness in maximizing shareholder value.

Also in pharmaceuticals, Bristol-Myers Squibb continues to pay CEO Richard L. Gelb 15 percent above the industry. This is despite the fact that 1992 shareholder value fell at over twice the rate of the industry (-21.2 percent versus -10.2 percent), and four-year shareholder returns grew 43.5 percent more slowly (13.9 percent per year versus 24.6 percent).
 % % %
Aerospace 79% 36% 43%
Automative 62% 46% 15%
Banking 50% 79% -29%
Chemicals 63% 63% 0%
Computers and Tech. 64% 64% 0%
Electronics 38% 44% -6%
Financial Svcs. 67% 50% 17%
Food and Beverage 50% 67% -17%
Industrial Eqpt. 67% 67% 0%
Oil and Gas 53% 53% 0%
Pharmaceuticals 54% 46% 8%
Pub. and Broadcasting 67% 56% 11%
Retailing 69% 69% 0%
Telecommunications 67% 53% 14%
Transportation 71% 64% 7%
Utilities 47% 27% 20%
Overall 60% 56% 4%
(*) Alignment occurs when companies fall into the high pay/high
or low pay/low performance quadrants.


These negative examples notwithstanding, it's clear that pay-for-performance continues to grow in popularity. But Clinton Congress, and the FASB have proposed changes in the current environment that could drop this healthy movement in its tracks.

Following up on his campaign promise (what makes this one so special?), Clinton has proposed limiting the tax deductibility of an executive's compensation to $ 1 million per year (with exceptions for "performance-based" compensation). Proponents apply the same logic they used to advocate the ERISA income maximums on qualified pensions: If companies want to overpay their CEOs, let them, but why should taxpayers subsidize the practice?

It's easy to point out the inherent illogic of the Clinton proposal, which implies that tax deductions for one person's talents (e.g., Michael Jordan's basketball prowess) are in the public interest, while deductions for another person's talents (e.g., Vagelos strategic leadership) are not. Even worse are the unintended consequences of the proposed tax legislation, such as those caused by the exception for performance based pay. Low-performing companies could resort to creative performance appraisals for their CEOs. High-performing companies could be forced to divulge business secrets such as strategic plans, performance objectives, and details on individual appraisals. How would this improve the country's economy? Or have the "retired" foreign lobbyists in Clinton's Cabinet gotten to him?

Congress, proposal is even more foolish. It would cap CEO pay deductibility based on a designated multiple of the lowest paid worker's annual pay. The consequence of this action would be to move virtually all low-wage jobs offshore (or off the books), thereby "raising" the pay of the lowest-paid worker and reducing the CEO's pay multiple but not his actual pay. Total tax revenues would decline, and welfare rolls would increase. Could this be Clinton's secret plan to create urgency for welfare reform?

The FASB's intention to expense stock option grants is the most destructive idea of all. Everyone can agree that stock options (and other forms of stock-based compensation) should be accounted for. Logically, they belong on the balance sheet (similar to today's option accounting rules) instead of on the income statement, because they represent a dilution of equity, not an expense. Unfortunately, the FASB is surrendering to misguided political pressure by advocating the expensing route.

Nobody at the FASB is asking: Whose interests are served by expensing opinions? Certainly not those of institutional investors, employees, entrepreneurs, and the general public. Institutional investors oppose the proposal. Employees understand that the plan will halt companies, efforts to expand option awards below senior management levels. Even the FASB agrees its proposal will hurt entrepreneurs the most, because they depend on stock option grants to offer competitive pay rates to qualified personnel and can ill-afford the new charges to their income statements. As for the public, almost anyone would agree that CEOs and other executives ought to tie their net worth to the growth of their companies and stock options are simply the most efficient way to accomplish this objective.


Finding ways to encourage CEO stock ownership is the most important executive compensation issue facing American business today. Chief executives who hold significant ownership stakes in their companies always put the interests of shareholders first, retain their long-term focus, and inspire organizational commitment by example. Clinton, Congress, and the FASB should look for ways to support ownership, not to discourage it.

In an upcoming issue of Chief Executive, we will present new ways to ensure that the CEO--and his team of executives-build sustained ownership stakes in their companies. Meanwhile, we offer a modest proposal on how to reverse the biggest public obstacle to CEO ownership, the IRS Code limitations on incentive stock options. Two parts of the code are particularly destructive--the maximum annual grant value of $100,000 and the requirement to exercise ISOs sequentially, based on when they were granted (so that an earlier grant at a higher exercise price that is now underwater could block a more recent, in-the-money award).

We recommend removing these ISO restrictions from the IRS Code. By doing so, ISOs would become a viable way to motivate CEOs and other senior executives. As a result, CEO ownership would increase dramatically, because the executive would no longer need to sell exercised shares to pay taxes on the appreciation. (ISO appreciation is taxed as capital gains at the time the share is sold.)

Other benefit of this liberalization of the ISO rules are equally significant. Financial accounting and tax accounting treatments would be consistent under traditional FASB rules, because there would be no company tax deduction in the amount of the CEO's gain. This would eliminate a principal rationale for the FASB's proposed new option accounting rules. Plus, tax revenues actually would increase over time because of the elimination of the company tax deduction. Therefore, by amending the ISO rules, the IRS would be be helping shareholders and taxpayers alike.

A proposal that sharply increases CEO accountability and helps reduce the national deficit--are you listening, Bill?


CEO pay Lata for the most recent fiscal year were analyzed from annual reports and proxy statements for a sample of 244 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 1989 to 1992 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 years 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 to reflect forfeiture risk If the proxy statement does not disclose average vesting, we assume five years and discount 25 percent.

* 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 growing the 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 a measure of ownership calculated in the same way as the Leverage Index, except that the numerator includes the appreciation in value of all
COPYRIGHT 1993 Chief Executive Publishing
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:CEO Compensation; includes related article
Author:Meredith, David R.
Publication:Chief Executive (U.S.)
Date:Sep 1, 1993
Previous Article:Lorenzo Zambrano.
Next Article:It's about markets, stupid.

Related Articles
CEO salaries in 1991.
Exploding myths of CEO pay.
Tracking pay for performance.
Harnessing corporate horsepower: the new principles of CEO compensation.
CEO compensation: share the wealth.
Does your boss make too much?
CEO compensation: the whole truth.
CEO compensation: greed or glory?
Compare & Contract.
Pay crackdown: at leading companies, compensation committees make changes to heed criticism of egregious pay. Washington likely will spur others....

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters