CEOs and the Pay-for-Performance Puzzle

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Short-Term or Long-Term Performance?

Infuriating to the public and even many compensation experts is the process by which CEOs profit while their companies do well, but are protected when they do poorly.

"You can't just have the executive enjoy the upside," says Aditi Mohapatra, an analyst with Calvert Investments, a socially responsible investment firm that has focused on reforming executive pay schemes. "Along with shareholders, they have to experience the downside as well."

The concept of performance can be hard for boards to define. Should measures be short-term or long-term? And compared to what?

Irani can claim a job well done, but there's no doubt his firm benefited from rising oil prices. The Corporate Library notes that seven of the 10 highest-paid CEOs in 2008 were petroleum executives.

Corporate boards may set short- and long-term objectives for their executives to meet. But a crisis, a recession, or even an unexpected boom can make those benchmarks irrelevant. Setting long-term goals is especially difficult in a volatile environment like this one, says Don Lindner, manager of executive compensation for WorldatWork, a nonprofit association of human resources professionals focused on compensation issues.

Golden Parachutes Out of Fashion

Lindner says corporate boards are spending much more time these days crafting compensation plans. They're ending much-criticized "golden parachute" payments and shifting rewards from short-term goals to long-term accomplishments.

"I don't think you're going to see pay go down," he says, "but you're going to see a better alignment between pay and performance."

Investors such as Brian Washkowiak of Talon Asset Management say vaguely worded compensation policies—which lack specific benchmarks or goals—can be a dangerous sign that a company is poorly run. "We're trying to find management teams that are better aligned with shareholders," Washkowiak says.

William Rutherford, president of Rutherford Investment Management, agrees. "When you see excessive compensation packages, you become concerned about the governance of the company," he says.

High pay—or big bonuses—can give executives an incentive to take big risks or even distort results, Rutherford says.

"Say on Pay" Proposals

One proposed solution is to have shareholders conduct a nonbinding vote each year on a public company's compensation package. That's the proposal in front of Congress. On Sept. 18, Microsoft (MSFT) voluntarily agreed to a "say on pay" vote every three years. On Sept. 21, General Mills' (GIS) shareholders narrowly approved a nonbinding resolution urging its adoption of a similar proposal.

Shareholder votes might make boards pay more attention to how they're compensating executives, but they don't solve the many difficulties inherent in pay packages.

Setting goals, particularly long-term goals, is difficult in an uncertain world. Companies and shareholders love to reward successful executives, but they're also reluctant to punish leaders when times are tough—for fear of scaring off good managers when they're needed most. The same incentives that reward good performance can also reward excessive risk-taking.

Finally, as the last couple of years have shown, so much—both good and bad news—remains beyond the control of a chief executive. To be sure, corporate chieftains can typically boast of advanced academic degrees and lengthy industry experience. These are clearly smart people. But in the volatile world of the 21st century, luck has a nasty habit of trumping skill—and CEOs are no exception.

See the attached slide show for examples of 25 well-paid CEOs and their track records over the last decade.

Steverman is a reporter for BusinessWeek's Investing channel.

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