Are We Over-compensating?

There’s a general consensus that says pay should reflect performance, but that hasn’t always been the case. Now, shareholders have had a gutful of executive greed and want to ensure CEOs work for their rewards.

Several high-profile CEOs have recently been forced out of their companies over compensation concerns following less-than-satisfactory tenures at the top. CEOs Hank McKinnel and Bob Nardelli both made headlines after they were ousted by disgruntled shareholders who claimed that their enormous salaries were undeserved. In fact, there has been much condemnation of the overblown salaries that many CEOs are awarded, particularly in light of the fact that the average worker salary is rising disproportionably in comparison. In 2005, the average CEO of a Standard & Poor’s 500 company received $13.51 million in total compensation, according to an analysis by The Corporate Library. With annual earnings often topping this figure, many are now asking whether paying these prices is really worth it. It seems shareholders have had enough and more heads are likely to roll in the future.

“There’s no question we’ll see more and more CEOs dumped because of excessively high compensation packages,” foresees Steve Cody, Managing Partner and Co-Founder of strategic communications firm Peppercom. “The system is broke and needs to be addressed by a governing body.”

The obvious assumption is that CEOs are paid according to the performance of the company they helm. Often, however, this simply isn’t the case, with directors becoming overly focused on attracting the best CEOs to their organization, regardless of the cost. Attracting and retaining the top talent often comes with a hefty price tag attached, therefore compensation packages can be disproportionately excessive. If a company performs well following the appointment then the high price tag can be justified. However, it is unsurprising if anger is directed at those who are still rewarded with a sizeable paycheck even if they underperform.

In the case of Hank McKinnel, former CEO at Pfizer, shareholders were disheartened that despite stock falling 40 percent during the five years he was in charge, McKinnel still left the company with a retirement and severance package valued at nearly $200 million. Meanwhile, the six-year tenure of Home Depot’s Bob Nardelli oversaw a period during which the company’s stock performance fell 7.9 percent and, as a result, many shareholders questioned the justification for the enormous pay package of $123.7 million (excluding stock options) he received.

These failures can be contrasted with CEOs who are currently succeeding and increasing their company’s stock. Lloyd Blankfein at Goldman Sachs Group Inc. and John Mack at Morgan Stanley are notable examples. Goldman Sachs’s stock performance under Blankfein was up 56 percent in 2006 (earning him compensation of $53.4 million), while the stock performance at Morgan Stanley was up 44 percent under John Mack (compensation of $40 million). “Even if the CEO is paid what appears to be an astronomical amount, as long as the CEO has helped to add value to the company over and above what he or she is paid then that’s a net positive to the company,” says David Zion, an Accounting Analyst at Credit Suisse.

So, exactly how is CEO compensation determined? “It seems as if the compensation of every CEO at every company is determined slightly differently in each case,” suggests Zion. “However, one thing that many CEO compensation schemes seem to have in common – at least when they are initially set up or when they are being renegotiated – is some type of peer group comparison. Coupling that comparison with a bit of one-upmanship may have helped to drive CEO pay higher.”

Company directors are usually at the heart of deciding how much a CEO should get. Normally the CEO will receive a salary, bonus, stock options and deferred compensation, along with other perks. These other perks may be as generous as the $10,000-a-month allowance given to ex-Disney CEO Michael Eisner toward maintenance of his apartment in New York, or Time Warner paying CEO Richard Parsons a $4000 monthly housing allowance (along with $365 for utilities) for an apartment in Los Angeles.

Often, directors justify the massive pay package by claiming that the presence of the CEO increases the value of the company. Despite this claim, there is little evidence that more pay results in better performance. Sometimes, the corporate board deciding the pay may put their own interests first, particularly if any of the directors work at the company and have to report to the CEO.

“In theory, independent compensation consultants advise an independent compensation committee on pay levels that are allegedly based on market research,” says Paul Hodgson, Pay Analyst at the Corporate Library. “But in too many cases, market research is typically flawed, the compensation plans are poorly designed, and the compensation committee is too much in awe of the CEO and the CEO’s lawyer to say no to any request.”

Painting a poor picture
The moral of the Nardelli and McKinnel stories is that you don’t always get what you pay for. In fact, both cases have reflected badly on the reputation of their companies, particularly that of Home Depot where their once friendly image has been badly tarnished by this scandal and other public relations blunders. “I find the CEO sacking crisis fascinating from an image and reputation standpoint,” argues Cody. “Here we have this mega retailer trying mightily to reinvent itself and expand its target audience as it battles Wal-Mart and other market pressures. Now, when ‘trust’ has been verified as a huge factor in consumer buying decisions, we see a CEO walking away with hundreds of millions of dollars after doing a mediocre job at best. How does Home Depot re-establish credibility with the masses after that?”

Stock option backdating also seems to have been a trend amongst CEOs who have been forced out of office. Stock options are a good way for companies to retain and attract staff, and although not completely illegal there have been many high-profile cases of executives who have seemingly manipulated the system. These include the high profile cases of Comverse Technology’s CEO and the CEO of Vitesso Semiconductor Corp. Stock options should act as an incentive for executives to increase the company’s stock price. Executives can benefit from any increase in value between the stock price at the date of grant and the stock price at the date of exercise. However, concern has arisen when grants happen to always appear on days when the stock price was very low, resulting in much higher earnings. Zion identifies how this kind of behavior is being taken into account by the shareholders. “More and more shareholders are performing a cost-benefit analysis when thinking about CEO compensation, with the CEOs compensation as the cost and the benefit being how much incremental value the CEO has helped to add to the company. It’s when the costs outweigh the benefits that shareholders get concerned,” he says.

“One example where the costs were apparently understated is stock option backdating, and investors aren’t happy about it. We would not be surprised to see more companies get caught up in the options backdating scandal. However, we hope it’s primarily a behavior of the past as both the accounting and disclosure rules that allowed this to happen have been tightened.”

It is not only the shareholders that feel disgruntled by excessive CEO pay, but also workers. Average CEO compensation for large US companies in 2005 was 369 times the pay of the average US worker, in comparison to an average of 85 times in 1990. According to Zion, excessive executive compensation does not really have the best effect on workers. “As an employee, shareholder or any stakeholder in the company you want to see people paid fairly, whether it is the CEO or line worker. If there is a group of people or one person that is being paid excessively, this will send out the wrong message. For example, employees might think they are being paid less so the executives can be paid more, which can have a negative effect on employee morale and turnover.”

Performance-related pay
Working out CEO pay so that it is fair should be quite simple: it should reflect performance. “It needs to be more effectively and demonstrably related to performance,” says Hodgson. “In Nardelli and McKinnell’s case, stock price was either flat or downward moving and they were paid millions of dollars during their tenures as CEOs. Not that stock price is the only appropriate measure, but then nor is net income or EPS.”

This view is supported by Cody, who believes that the majority of CEOs of publicly traded companies are overpaid and that there needs to be a change in the system. “Corporate boards/corporate governance needs to be overhauled and CEO compensation dramatically lowered,” he says. “I suggest something along the lines of the way in which ad agencies are paid: a basic fee loaded with incentives based upon actual sales performance.”

Home Depot have obviously already take heed of this advice, with new CEO Frank Blake having to prove his worthiness. Blake will receive a base salary of $975,000 and will earn more depending on whether the company meets the board’s profit and stock performance goals.

As the embarrassing departures of the abovementioned CEOs has proven, pay should be in relation to a company’s performance and it is almost certain that shareholders will in future become much more vocal in demanding that pay is a fair reflection of this. “The future of CEO pay is clear,” insists Cody. “Bellwether corporate boards will take the lead and the pack will follow.”