An Open Letter to All Journalists (this op-ed was written in the Summer of 2006, but still valid years later)
This letter indirectly responds to the May 3rd opinion column - "Surprise! CEOs are Still Highly Paid!" - by Holman Jenkins in the Wall Street Journal, but I label it as a letter to all those that cover executive pay since so many myths and so much misinformation regarding executive compensation appear in the daily press.
As it should become clear from the six "realisms" (to borrow a term from Mr. Jenkins) explained below, the principal cause for concern over CEO pay today is that the pay-setting process is broken - and has been for well over a decade. For most companies, I agree with Mr. Jenkins that high compensation levels don't relate to greed nor are they "the product of a corrupt bargain with crony boards."
However, I challenge anyone really interested in learning about this topic to take a few minutes to read our "12-Step Roadmap to Responsible CEO Pay" on CompensationStandards.com before they fall into the trap of repeating the myths that I counter below:
Realism #1 - Market Forces Do Not Set CEO Pay
Apologists for high levels of CEO pay often state that market forces set CEO pay, calling on a fundamental tenet of capitalism. This is a bit of a misstatement. Hard negotiation rarely occurs between a CEO and the board of directors. This is not the same process as Tom Cruise's agent and a studio head hammering out the next film contract over lengthy negotiations.
Ed Woolard, the former DuPont CEO, describes the process as "the compensation committee talks to an outside consultant who has surveys that you could drive a truck through and pay anything you want to pay, to be perfectly honest. The outside consultant talks to the HR vice president, who talks to the CEO. The CEO says what he'd like to receive. It gets to the HR person, who tells the outside consultant - and it pretty well works out that the CEO gets what he's implied he thinks he deserves so he will be 'respected by his peers'."
I chuckled when I read Mr. Jenkin's rationale for paying one CEO a large sum: "he is a rich man and could be on a beach." The same logic clearly can be used to argue that paying him less wouldn't lead to his departure - since it appears that the man serves as the CEO for more than monetary reasons. Otherwise, he would be on that beach today.
Realism #2 - Imperfect Peer Benchmarking Surveys Set CEO Pay
When a new CEO is hired, the CEO comes from either inside the company or recruited elsewhere. If an insider is promoted, the pay package often is set based on what the outgoing CEO made and by benchmarking what CEOs make at peer companies. Similarly, if an outsider is brought in, the pay package is based on what the CEO gave up to take the position and what peers make. All of this sounds perfectly reasonable - and it is.
The big problem here is that an incredible amount of inflation has been baked into peer benchmarking surveys over the past 15 years (ever since those databases were first constructed in the aftermath of the SEC requiring more detailed disclosure about pay levels in 1992). As boards of each company strove to pay the CEO of their company in the top quartile year after year, these survey numbers have skyrocketed above what the rest of the workforce is paid. This well-documented "ratcheting up" effect is compounded each year as part of a never-ending cycle. And the process is even less robust when boards consider annual adjustments to an incumbent CEO's pay, as reflected by Mr. Woolard's comments in Realism #1 above.
These benchmarking surveys understandably are relied upon by boards, as the concept seems simple enough and the same process often is used to set pay levels for all employees. Unfortunately, the database is full of bad data. The end result is that many decisions by boards aren't the byproduct of deep thought over how to best incentivize or retain CEOs. They often are the byproduct of a rote - and very broken - process.
Realism #3 - Stock Options Were Never Supposed to Be Considered Compensation
To fully understand how the peer benchmarking process got broken so fast, it helps to understand the history of stock options because options have become such a huge component of most CEO pay packages (even though large grants of options best fit companies in the "venture capital" stage of their life cycle, as compared to the more mature parts of the cycle - too often large grants are given to CEOs of mature companies). Set forth so succinctly in a speech given last summer on CompensationStandards.com, well-respected compensation consultant Fred Cook, Chair of Frederic W. Cook & Co. with more than 40 years of experience under his belt, explains it as follows:
- Not Intended as Compensation - Stock options were
not intended originally to be compensation, but rather an ownership
incentive. There was no cutback in current compensation to make
room for stock options; they were on top. The whole premise of
stock options, and other equity incentives for that matter, was not
to compensate people, but to make non-founder executives and other
key employees think and act like shareholders in managing the business on behalf of the absentee shareowners.
- Could Not be Valued as Compensation - Since they
were not intended as compensation, and in the early years could not
even be valued, questions arose as to how grants should be
administered. The typical pattern then was to think of the grant
size in terms of "face value," namely the number of option shares
granted times option price. This face value was then ratioed as a
multiple of salary for administrative purposes. For example, the
top people might get a grant of one to five times salary, with the
multiples decreasing at lower levels. The general idea was that,
over time, executives would accumulate a "carried interest" in their
company's stock price appreciation that would be motivational to
them relative to their annual income and other benefits from company
employment. This, frankly, is a very simple and logical approach,
first espoused by Mr. Crawford Greenwalt, President of DuPont in the
- Consultants Regularized Practice - Consultants then
got involved in the process when companies and boards sought their
advice for how to administer option plans. So, consultants started
surveys of other companies' option grant practices, typically
measuring grants in terms of the face-value multiples of pay as
described earlier. Consultants also annualized option grants to
include them in their annual surveys, even if the early adopters of
options never intended options to be granted regularly to the same
executives year after year. It was compensation professionals, with
their penchant for order, regularity, measurement and comparability,
that made stock option grants a regular part of the annual
- Option Valuation Made Possible - In 1973, the
Black-Scholes formula for valuing traded options was first
published. It took several years before its possible application to
executive compensation was recognized and absorbed. Then it became
possible, for the first time, to put a present value dollar amount
on stock options and to combine the results with salary and bonus
income, making option grants fungible with other compensation
elements. The survey professionals quickly adjusted their survey
models to accommodate stock option grant values in total
compensation. They found that the wide variety in practice, as one
would expect, produced a large number of companies (roughly half of
any survey population) whose total compensation was now below
average, thereby creating a market for consulting assistance to
correct this competitive shortfall.
- New LTI Forms Developed - During this same period
of the '70s and early '80s, the stock market was in recession and
stock options were perceived as having little value. Various
enterprising consultants and strategic thinkers devised new forms of
long-term incentives, both equity based (like restricted stock and
performance shares), and cash based (like long-term performance
units), to motivate and reward senior management for long-term
actions that would benefit company performance over the long run,
even if not recognized by the stock market. With Black-Scholes
providing the key to valuing stock options, and consultants
providing the survey information to assess how far behind one was in
total compensation, it became a relatively easy matter to either
carve out of option values amounts that could be converted to these
new forms of long-term incentives, or just add the new forms on top,
particularly if one was low anyway.
- The Golden Years of Options - The mid '80s saw a
resurgent stock market, which continued with minor interruptions
through early 2000. Stock options regained their supremacy as a
long-term incentive. And these other equity forms, such as
restricted stock, performance shares and long-term cash, treaded
water. This was the same period when (1) corporate raiders
threatened to take over and break up companies whose stock prices
did not reflect their inherent values, (2) LBO firms emerged to make
sweetheart deals with managements of companies to take them private,
and (3) institutional investors and other shareholder advocates led
an assault on corporate boards and managements under the
high-sounding mantra that shareholder-value creation should be the
overriding, if not sole, purpose of public companies.
- Shareholder-Value Creation Pre-eminent - Boards,
managements, compensation consultants, and academic theorists
responded to these both positive and negative pressures all
throughout the 1990s by rapidly increasing the size of stock option
grants and total share usage for stock options. Even conservative
boards of directors, who did not want to get too far ahead of market
medians, were helped by a particular quirk in the Black-Scholes
formula, namely the higher the stock price at grant, the greater the
option grant values, all other things being equal. Thus, during a
period of rising market values, consultants were able to show that
total compensation from options was rising, even if the survey
companies granted no more shares from one year to the next. This
created another reason for relying on consultants and surveys. If
your company lagged the growth in market values, then you had to
increase the size of your grants just to remain competitive.
- Mega Grants Made Regular - For a variety of reasons, some valid and some less so, many companies made "mega grants" of stock options, restricted stock, or performance shares during this period. These were very large grants, for example, three or more times normal. They were designed for special purposes, for example, to attract a new senior executive, recognize a significant promotion, retain potential CEO replacements, signal a new strategic direction, bring merged company managements together, transform performance to a higher plateau, or just because others were doing it.
- Regulatory Requirements Favored Options - I would
be remiss in not mentioning the role that favorable accounting
treatment, tax consequences, and SEC reporting requirements for
stock options had in contributing to the upsurge in their usage.
- Converting to Real Compensation - Finally, now that options are "expensive" under new accounting rules, companies are shifting to other equity devices deemed more likely to deliver steady compensation based on performance. The problem is that we are now shifting to these newer forms of equity incentives from a position of very high stock option grant values, which were created under totally different circumstances and sustained by competitive surveys using the Black-Scholes formula, which overvalues employee options versus traded options.
Whether for good purpose or not, the problem occurred when consultants included the mega grants in their surveys, annualizing them as if they were a regular, ongoing part of total compensation. This escalated long-term incentive survey data significantly. While mega grants are rare today, their residual effect remains in the survey numbers.
Realism #4 - Boards Often Didn't Know How Much They Gave
Perhaps picture proof that boards are not necessarily "croony" is that, at least until recently, they didn't even know how much total compensation they gave to a CEO. Until last year, we are not aware of a single board that used a "tally sheet." A "tally sheet" is one sheet of paper that lists all the different pay elements of a CEO's pay package. Now being widely implemented, this exercise often results in a "Holy Cow" moment for the board when they first conduct it and realize how much they have granted.
You might ask: "How can this be?" The answer is that beyond salary and bonus, many other pay elements can be quite complicated, with formulas that don't easily reveal the true magnitude of the resulting huge payment obligations. And many boards granted new awards without recognizing how much was already on the table. In addition, it was not uncommon for various pay elements to be approved at different board meetings, adding to the confusion.
Realism #5 - A CEO's Retirement Package is a Misnomer (and Other Misunderstood Pay Elements)
Here is just one example of a pay element that boards often don't understand. Many CEOs have been the benefactor of boards placing them in a supplemental executive retirement plan; such SERPs enable executives to be paid beyond the IRS limits for qualified pension plans. Quite a few boards gave CEOs these plans without realizing how large the numbers could grow: ExxonMobil's Mr. Raymond's $98 million, Pfizer's Dr. McKinnell's $83 million, etc.
As these amounts reveal, these really aren't retirement packages at all since they go well beyond the purpose of a retirement plan (i.e., enable you to live comfortably for your remaining days). One respected compensation consultant says that boards should view SERPs as the equivalent of restricted stock that is simply paid out in cash. As a result, they should be treated as a form of long-term compensation, and that those companies that have both SERPs and restricted stock (or other long-term compensation) are, in essence, double dipping. There are quite a few double dippers out there.
Investor ire peaks when it comes to severance packages. Investors are troubled by the numerous cases of executives walking with a huge severance payment when the CEO was essentially fired for poor performance. Investors understand that these arrangements don't jibe with the underlying purpose of severance pay (i.e., to tide you over until you can obtain another job). For some reason, many boards don't seem to get it - they provide these packages because "everyone else is doing it." At the expense of shareholders!
Realism #6 - Some Boards Need a Kick in the Pants
Mr. Jenkins's final comment that high CEO pay exists because that's what intelligent, savvy investors want begs the question - which investors has he been talking to? If you talk to any investor, you will quickly recognize that there is a growing movement of disgusted investors who can easily see through the many pay arrangements that simply don't make sense.
For example, look at this excerpt from a recent New York Times article:
"When President Bush nominated Steven C. Preston last week to head the Small Business Administration, Mr. Preston already had his golden parachute strapped on. Mr. Preston, 45, was an executive vice president of the ServiceMaster Company, a conglomerate of household services like lawn care and bug-killing. But on March 1, he struck a flexible arrangement to depart sometime in the next four months and collect $2 million in severance.
''We had some anticipation that this nomination was going to come through,'' a ServiceMaster spokesman said. In exchange for the money, which is double Mr. Preston's annual salary and target bonus, he agreed not to compete with ServiceMaster for two years. That should not be a problem, unless the administration decides to go into the extermination business."
If there is some logic in this arrangement, it certainly escapes me. How did the ServiceMaster board believe that giving $2 million to a departing CEO is in the best interests of shareholders? This flies in the face of the many "retention bonuses" paid annually. These types of questionable practices are not limited to the Enrons of the world (including many questionable perk practices too numerous to name here), they are widespread.
How to Fix It
Broken pay processes exist at thousands of public companies. These companies are not engaging in fraud, but are merely following processes and practices that have been passed down through generations of director changes. The numerous boards that want to do "the right thing" have been taken down a path that can be challenging to correct, mainly because there is so much misinformation to get past.
But fixes are available - and necessary. Some of them are simple, some of them are not. It will take backbone by boards and CEOs to implement them. For example, peer group benchmarking can be balanced with internal pay benchmarking (e.g., benchmarking the CEO's pay against the company's other senior managers or the company's entire employee base). This is the mission of CompensationStandards.com - to provide the tools that boards can use to make these fixes.
To join those boards that have some backbone and are willing to make the necessary fixes, you are encouraged to watch this 10-minute video of former Dupont CEO Edgar Woolard, who currently serves as the head of the NYSE's compensation committee: Ed Woolard's Candid, Inspirational Challenge to CEOs and Directors.