Tying pay to performance is a great idea. But stock-option deals have compensation out of control
It seems to have worked like a charm. In recent years, as boards shifted the mix of executive pay away from cash and toward stock options, corporate profits and the stock market have vaulted to record levels. It's exactly the win-win situation that pay for performance was expected to bring: more reward for the leaders and better returns for shareholders, who can sleep well knowing that executives feel the same pain they do if their companies underperform.
It's a soothing lullaby, but shareholders are starting to wake up to some sour notes. The explosion of executive pay--propelled by huge option grants, easy performance provisos, and a bull market--has created a windfall for all. Star CEOs are winning big, but so are many second-stringers. Even for the success stories, the CEO's gains often exceed the company's own strong year proportionally. And while the mass embrace of options has helped shareholders, options have hidden costs and are diluting those gains to the tune of tens of millions of dollars.
Few doubt 1996 was a stellar year. The Standard & Poor's 500-stock index rose a stunning 23%. Corporate profits rose, too--an impressive 11%. Who would begrudge U.S. chieftains a healthy raise?
Apparently, no one. But many CEOs took that--and a good deal more. For 1996, CEO pay gains far outstripped the roaring economy or shareholder returns. The average salary and bonus for a chief executive rose a phenomenal 39%, to $2.3 million. Add to that retirement benefits, incentive plans, and gains from stock options, and the numbers hit the roof. CEOs' average total compensation rose an astounding 54% last year, to $5,781,300. That largesse came on top of a 30% rise in total pay in 1995--yet it was hardly spread down the line. The average compensation of the top dog was 209 times that of a factory employee, who garnered a tiny 3% raise in 1996. White-collar workers eked out just 3.2%, though many now get options too.
It all adds up to quite a payday--and one that's raising a storm of criticism. "We've got terrible tensions this year" with institutional investors, says Pearl Meyer, president of pay specialist Pearl Meyer & Partners. Even many shareholder advocates who pushed for the move to pay for performance in the early 1990s question whether the approach is working. As once-outsize options packages become the norm, many CEOs are taking the lion's share. Far smaller gains are going to managers and other key employees. The disturbing message: The CEO deserves nearly all the credit for the company's success. Worse, there's very little downside to many CEO pay deals. Many executives are negotiating big guaranteed payouts in case they stumble. And if the market drops, some pay experts worry that executives will demand--and get--options at lower prices to ensure that their pay packets remain full.
What are the main results of BUSINESS WEEK's 47th annual Executive Pay Scoreboard? Compiled with Standard & Poor's Compustat, a division of The McGraw-Hill Companies, the survey examines the compensation of the two highest-paid executives at 365 of the country's largest companies. In comparing pay with performance over three years, BUSINESS WEEK found that Microsoft's William H. Gates III and Avon Products' James E. Preston gave investors the best results for their pay (page 61). Conseco's Stephen C. Hilbert and America Online's Stephen M. Case were the worst-performing CEOs relative to payouts.
Despite the soaring pay, many experts argue that the system is working better than ever. They see the bull market and healthy corporate sector as proof positive that companies get what they pay for. They argue that as long as CEOs continue to turn in strong results for their shareholders, the absolute level of executive pay is irrelevant. "You can't legislate morality," says James E. McKinney, consultant at pay experts Hirschfeld, Stern, Moyer & Ross Inc. "The U.S. is the most exciting economy the world has ever seen." Adds Charles W. Sweet, president of A.T. Kearney Executive Search: It's simply "the cost of finding brains."
LITTLE-KNOWN LEADER. In many cases last year, those brains cost a lot more. The top ranks were peopled by such corporate standouts as Intel's Andrew S. Grove, who earned $97.6 million, and Travelers Group's Sanford I. Weill, who made $94.2 million, most of which remains in Travelers stock that he can't sell until he retires. Heading our list for the second straight year was Lawrence M. Coss, the little-known CEO and chairman of Green Tree Financial Corp., based in St. Paul, Minn. Thanks to a five-year deal set in 1991 that paid him 2.5% of pretax income, Coss made $102.4 million last year--a 56% rise over the $65.6 million he earned in 1995.
By any standard, Coss's paycheck is huge. And for many investors and pay experts, he remains the poster boy for all that is right with pay for performance. Coss himself makes no apologies. "Indeed it is a huge number," he says, "but I'd rather talk about the success of the company." That's easy to do. Between 1991 and 1996, Green Tree's shares had compounded annual returns of 53% as it became the largest lender to the manufactured-home sector. Although two small pension plans recently sued Coss and the board for excessive compensation, most big shareholders appear satisfied. "In no way would I consider him overpaid," says Thomas W. Smith, partner at Prescott Investors Inc., which holds 2.7 million shares.
Like Coss, most well-paid execs point to stock gains as proof that their pay is richly deserved. Ask Sam Wyly, chairman of Sterling Software Inc., about the fact that his $439 million company produced three of the biggest pay packages in Corporate America last year, and he lets out a belly laugh. "We should," he says, pointing to the company's 673% stock price rise since its 1983 initial public offering. The payouts--which totaled $69.6 million for Wyly, $34.7 million for his brother, vice-chairman Charles J. Wyly Jr., and $58.2 million for CEO Sterling L. Williams--came mostly from option exercises.
Yet if few would dispute the success of such fast-growing companies, investors are increasingly asking how much is enough to get top performance. Again, take Coss. His pay is so gargantuan that it dwarfs his stellar performance. The ratio between his three-year pay and the shareholders' return puts Coss third on BUSINESS WEEK's list of CEOs who gave shareholders the least for their buck. Moreover, the huge award significantly diluted other shareholders' gains: Coss's payouts cut Green Tree's 1996 earnings 16%, to $308.7 million.
Because he received shares directly, rather than options, Coss's compensation differs from that of most CEOs. But as the sheer number of options has soared, shareholder dilution is proving an unanticipated by-product. Companies use options in part to align executives' interests with shareholders. But they also favor them because--unlike other forms of pay--they never show up on an income statement. Instead, starting this year, companies must footnote them in their annual reports using the Black-Scholes fair value option pricing model.
It takes some digging, but those footnotes provide plenty of surprises. For all the benefits that options create, they're not free. PepsiCo Inc., for example, reported that its option grants would have reduced earnings by $68 million, or 6% last year, had they been counted as compensation. Medical-equipment maker Guidant Corp.'s earnings after charges would have taken an 11% hit. By putting more potential shares into circulation, options reduce every shareholder's slice of the earnings pie. And because the footnotes include only options granted since 1995, Bear, Stearns & Co. accounting analyst Pat McConnell estimates they understate the impact by at least 50%.
CONCERNED INVESTORS. Companies with broad-based option plans say the dilution is a small cost next to the benefit of motivating employees. But the largest share of those new options goes to the corner office. According to Executive Compensation Reports, a Fairfax Station (Va.) newsletter and database, 51% of companies that have reported granting options for 1996 have given 10% or more of them to the CEO. In 1993, only 18% of companies did so.
But that's not the only hidden cost of options. Companies have been buying back shares in record numbers, even as many sell discounted shares back to executives when they cash in their options. With many shares trading near record highs, those companies are paying top dollar to buy back stock--while execs pocket the aftertax difference between the option price and the market price. That often results in large cash outlays, and it also means executives end up with an ever higher percentage of outstanding shares. "Want to talk about the largest social welfare transfer program in the world?" says Patrick S. McGurn, director of corporate programs at Institutional Shareholder Services Inc., a proxy advisory service based in Bethesda, Md. "It's from shareholders into the pockets of executives."
So far, investors have been relatively quiet on dilution. But now they're taking notice. Institutional Shareholder Services is recommending "no" votes against at least 20% of new stock-option plans, including those at Starbucks Corp. and Sprint Corp. And the five New York City pension funds will oppose some one-third of plans this year, primarily because of concerns over dilution. Options "do come home to roost," says Jon Lukomnik, New York City Deputy Controller for pensions.
Another unwelcome result of the shift to pay for performance: It's not just the best who are pulling in giant pay. Performance targets are often set so low--or so loosely--that they're virtually meaningless. "Performance criteria are almost like intellectual Silly Putty," says Warren Bennis, Distinguished Professor of Business Administration at the University of Southern California's Marshall School of Business.
According to Executive Compensation Reports, of proxies examined so far this year, only 6.6% of option-granting companies issued any "premium-priced" options--those with prices above market value on the day of issue. And though the number is up from last year's 3.5%, most companies boasting premium-priced options make them only a small portion of the package. Just 20% of PepsiCo CEO Roger Enrico's 1.7 million stock-option awards in 1996 were made at prices above then-current market value, for example. And of last year's record-setting grant of 8 million options to Walt Disney CEO Michael D. Eisner, only 3 million were awarded at above-market prices.
Shareholder advocates say that tougher targets are necessary to keep from rewarding average CEOs who are simply riding a bull market. Nell Minow, a principal in LENS, an activist investor group, argues, for example, that executives should outperform the market or their peer group to receive big packages.
Instead, with grants in the hundreds of thousands of shares now commonplace, managers can earn a big payday even if their stocks rise only slightly. In Eisner's case, if Disney shares rise a tiny $2 annually--a poor performance by Disney's standards--the value of his market-priced options would increase $10 million annually. And there's little real downside. Few executives suffer financially if the stock drops. "One of my biggest complaints is there's not much risk" with options, says Anne Yerger, director of research at the Council of Institutional Investors. "In a bull market, most executives are going to get money."
LOSING THE BALANCE? As a result, many execs whose performance trailed their peers' have also benefited. Typical was H.J. Heinz's Anthony F.J. O'Reilly, who made $64.2 million last year. His company's stock performance rose just 11%, trailing both the S&P and other food companies. O'Reilly defends his huge option grants as part of a generous incentive scheme. "There can be no more honorable or fairer way" to compensate CEOs, O'Reilly argues.
The staggering rise in pay for the good, the bad, and the indifferent has left even some advocates of pay for performance wondering whether the balance between the CEO and the shareholder is tilting the wrong way. "I've been consulting for over 20 years and have seen options accepted carte blanche as a good thing," says George B. Paulin, president of compensation consultancy Frederic W. Cook & Co. "Now, boards and investors are starting to question the structure of option deals."
In the meantime, many top execs have amassed vast troves of options that have yet to be exercised (page 66). Among those with the largest potential jackpots: Disney CEO Eisner, who holds some $364.4 million in unexercised stock options. The gains are so enormous that AOL's Case, who cashed in most of his $27.4 million in options before growing pains and accounting changes beat up the stock last year, is still sitting on options worth an additional $116.6 million. And topping the list is HFS CEO Henry R. Silverman, with $544.3 million in exercisable stock options.
The question, of course, is why boards don't set the performance bar higher. While compensation committees are much more vigilant than they've ever been, Kayla J. Gillan, general counsel at the California Public Employees' Retirement System, a $110 billion pension fund, points out that about 25% of the companies in the S&P still have an insider on the compensation committee. And companies fear they'll lose talent if their executive pay falls below that of their peers. That helps to inflate compensation. Says Howard B. Edelstein, a principal of the Todd Organization, a benefits consulting firm: "Companies are saying, `Take me to the middle."'
Despite recent requirements that boards disclose the criteria they use to set pay, there's plenty of wiggle room. At Mattel Inc., for example, newly named CEO Jill E. Barad wasn't eligible for a bonus in 1996 because the company missed internal targets. So instead, the board awarded her a $280,000 "special achievement bonus" for progress made in 1995. And like many executives, Barad has also negotiated protection should things at Mattel go wrong. If Barad is dismissed or leaves for "good reason," she'll receive five times her last salary plus average bonus, become vested in an executive retirement plan at the age of 50, and have a $3 million loan forgiven.
SELLER'S MARKET. Even those whose subpar performance makes their options worthless have recourse. For example, in 1995 Digital Equipment CEO Robert B. Palmer was granted 300,000 options at the then-market price of $48. The next year the package was smaller, but the exercise price fell to $37.75 to match the swooning stock. If the stock returns to its already depressed 1995 price, Palmer will pocket nearly $2 million.
Many consultants say companies, faced with executives who are more willing to job-hop, must dole out juicy options packages and guarantees to get the execs they want. It's a seller's market, with CEOs in demand holding most of the cards. "In many cases," says Peter T. Chingos, national practice director of compensation at KPMG Peat Marwick: "You don't have a choice."
And if the recent tremors in the stock market turn into an earthquake? With shareholder returns increasingly the gauge for setting executive compensation, the truest test of pay for performance may come in a bear, not a bull, market. Yet few expect CEOs, now accustomed to supercharged awards, to cut back. Instead, experts anticipate demands for lower-priced options or for more cash. "When stock prices go down [CEOs argue], it's purely the vagaries of the market," says Kevin Murphy, a professor of business administration at USC. "But when they go up, it's what they did to create value."
Already, the pressure to reprice has begun. After a difficult few years in the trucking industry, Jerry W. Walton, chief financial officer at J.B. Hunt Transport Services Inc. in Lowell, Ark., says he tried to get the top brass to reprice their options, which have fallen below market value, on condition that they surrender some of the stock. Included: a grant of 2.5 million options for Chairman Wayne Garrison. "Everybody thought it was a good idea to reprice," Walton says with a laugh. "Nobody thought it was a good idea to surrender [the options]."
Will executive pay ever descend from the heavens? Some who helped push the early-1990s reforms aimed at trimming exorbitant executive pay--and tying it more closely to performance--are cynical. "I wouldn't say the glass is half full; I'd say it's one-millionth full," says Minow. "I do think things have improved. But a lot of the reforms we thought would happen with executive pay have been ineffective." For shareholders, 1996 was a good year indeed. But it was a far better year for the boss.By Jennifer Reingold in New York, with bureau reportsReturn to top