Executives are increasingly being required to justify their sky-high pay deals with stellar performance. But the suspicion still lingers that top executive pay levels are over-inflated. Steve Coomber examines whether they are really worth it.
There are few things in business more contentious than executive pay – or more specifically CEO pay. When CEO compensation makes the headlines, it is usually for all the wrong reasons: sharply increasing salaries, abuse of perks, backdating options, and stratospheric severance pay coupled with poor performance.
Yet the job of a CEO of a large quoted company is a tough one. Hours are up, tenure is down and scrutiny is oppressive. Surely CEOs deserve significant rewards. And then there is the market. Companies pay the going rate, and a dearth of talent means paying more to get the best. So are CEOs overpaid or are they worth every cent?
Criticism of CEO pay levels is not surprising, given recent headlines. Chrysler CEO Bob Nardelli left Home Depot after six years with the stock price much the same as when he arrived, yet he receives more than $200m in severance pay. CEOs walk away with multi-million dollar payouts during the current sub-prime crisis. Former Pfizer CEO Hank McKinnell ends his five-year tenure with a $200m golden parachute, having presided over a period when stock price headed south. Intuitively, all this feels wrong.
Back in the 1960s, base salary formed a high proportion of the pay mix. Today CEOs of the top 10% of companies in the US by revenue receive median total compensation of $9.8m, with 50% of that in company stock and options. In the early 1980s, CEOs of the largest US companies were paid around 45 times the average worker’s salary. By 2005, CEO pay had run way ahead to an astonishing 263 times average worker pay.
A number of factors have contributed to the sizeable compensation packages we see today, and government intervention is not always helpful.
Don Lindner is executive compensation practice leader at WorldatWork, a US-based non-profit association focussing on the total rewards, including compensation and benefits, associated with attracting, motivating and retaining employees. Lindner says: "Every so often legislators and regulators get involved, intending to slow down pay growth. But often such intervention just contributes to the large packages we see today."
Lindner points to the US Internal Revenue Code section 162(M) $1m cap on the deductibility of executive compensation by a public company, introduced in the US in 1986, as an example of such an intervention. With high base pay no longer as tax efficient as it was, the inclusion of a performance-based compensation exception encouraged compensation designers to ratchet up annual bonuses and stock grants.
Other commentators point to seminal Harvard Business Review article, 'CEO incentives – it’s not how much you pay, but how', by academics Michael Jensen and Kevin Murphy, published in 1990. The authors argued that if CEOs pull down the same salary regardless of how successful their company is, there is little incentive for them to take the kinds of risks and initiatives that created sustainable, competitive businesses. The article helped justify the granting of stock options as a significant proportion of CEO pay.
But are big increases in CEO pay a bad thing? Any rational discussion about executive pay should start by considering the purpose of executive remuneration.
"Remuneration is designed to help the company meet its business objectives, and that means it has to measure and pay for the right sort of performance," says Carol Arrowsmith, head of remuneration at Deloitte, the tax and finance consultants. "Pay has to be structured in a way that the risks and rewards to shareholders are reasonably fairly balanced."
So how do we identify the right kind of performance? Shareholders might argue that the stock price is paramount, but CEOs have little control over that.
"With a volatile stock market, shareholder fortunes can change rapidly," says Mark Goodridge, chief executive of ER Consultants, which specialises in organisation behaviour change, often through modifying compensation and benefits practice. "But should executive pay fortunes fluctuate to the same degree when stock performance has a lot to do with market sentiment and overall economic performance."
Linking executive pay to total shareholder returns seems a sensible approach. "It is essential to align executives and get them to understand the need to create value for shareholders over the long term," says Lindner. "To some degree, that means tying their pay to that objective. If a company has targets for metrics such as cash flow, revenue or earnings per share growth, those targets should be among an executive’s annual and long-term incentives."
This leads us back to Nardelli. As Nardelli pointed out, on many measures, Home Depot’s numbers were impressive. Over six years, revenue was up from $45.7bn to $92.5bn, profit margin up from 5.6% to 7%, return on shareholder equity up from 17.2% to 21.5%, dividend up over 250%, and store numbers up, almost double, to over 2,000. Judged on this, maybe the flak he got was unfair.
Remember too that it was the board of directors, and not Nardelli, that sanctioned the compensation package on behalf of Home Depot. In theory, the board, and its compensation committee in particular, imposes sensible restraint on executive pay. Many would argue, however, that boards have erred on the side of reward as opposed to risk.
This is where the real challenge lies: the balancing, by boards, of competing requirements. There are ample reasons why boards might feel inclined to offer generous pay: a shortage of talented executives, the desire among CEOs for a higher salary, the influence of an array of actors in the recruitment process and a lack of relevant expertise among non-executives.
Meanwhile, there are factors that discourage the award of inappropriate pay increases: regulatory codes, legislation, disclosure rules, shareholder interests and a desire to incentivise the CEO in a meaningful way.
Getting remuneration right is a challenge. "One of the key challenges for most remuneration committees," says Arrowsmith, "is deciding what good, great, and outstanding success look like. If the non-executives set the targets too high, people will not stretch themselves and strive. If they are too soft, shareholders will legitimately worry that people are being rewarded for average performance."
If boards are struggling under the responsibility to determine executive pay, maybe shareholders – the owners – should have more say on compensation. There are moves in this direction. Since 2002, UK public companies must give shareholders an advisory vote on executive pay, a rule often praised by supporters of ‘say on pay’ in the US, where legislation has been passed by the House of Representatives and may get through the Senate.
Yet not all supporters of shareholders’ interests want legislated mandatory voting on pay.
Ultimately, executive pay is determined by market forces, not abstract notions of fairness, although the concept of fairness does come into it. The US leads the total CEO compensation rankings. However, in 2006, the Securities and Exchange Commission (SEC) unveiled new disclosure rules for executive compensation, creating greater transparency, albeit with some fudging on stock options. If anything has the power to stem the rise in executive pay it is this type of disclosure, and the resulting scrutiny.
Matthew Andrews, a partner in the financial services practice at senior executive search firm CTPartners, believes a more thoughtful approach to CEO pay is likely to emerge. Andrews says: "Heading into a recession, as we see more examples of charismatic leaders at companies failing, contractual positions where they must be paid substantial sums of money despite their failure will be questioned. There is likely to be more realism, more complexity and thought regarding senior level remuneration."
Hopefully this dose of realism will encompass performance incentives that cannot be easily manipulated and safeguard against practices such as options backdating.
Some major corporations are already taking a lead. American Express has just agreed a new incentive plan for CEO Ken Chenault. It is a groundbreaking deal. For a start, it is based on performance over six years, a very long time in terms of corporate fortunes and CEO compensation. Also, Chenault will be rewarded in options, not restricted stock, so there will be no automatic reward for marking time. And the targets are tough: earnings must be up by no less than 15% a year on average, revenue by 10%, and return on equity must be 36% on average. However, the real sting in the tail is the total return to shareholders: American Express must outperform the S&P 500 by 2.5% a year, on average.
So Chenault can forget about riding a rising market. American Express must beat the market average. Less impressive performance means a reduced grant of options. Below a certain threshold, Chenault gets no grant at all. If Chenault turns in that kind of performance, he will have earned every cent of his pay package.