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Getting a Grip On Executive Compensation

January 30, 2003
Related Topics: Finance/Taxes, Compensation Design and Communication, Featured Article, Benefits
For many years, General Electric represented all that was right with corporate America--soaring shareholder value, irreproachable governance, and a world-class management team driven by the top corporate general. But in September, cracks appeared in the foundation of the house that Jack Welch built. Revelations of retirement perks such as an $80,000-a-month Manhattan apartment, free satellite television service in four residences, and 24-hour access to a corporate jet did not sit well with the public.

The very idea that the SEC would target a paragon of corporate America because of an excessive compensation package illustrates the mood of the country: enough is enough.

    After details about his prodigious package appeared in newspaper stories and gossip columns--information that surfaced during his divorce proceedings--Welch promptly, and voluntarily, pared down the terms of his retirement agreement. His swift response quelled an informal investigation launched by the U.S. Securities and Exchange Commission, and eventually quieted the tabloids. The very idea that the SEC would target a paragon of corporate America because of an excessive compensation package illustrates the mood of the country: enough is enough.

    Federal Reserve Bank of New York president William McDonough chose a September 11 commemoration in New York City to censure CEOs for the "over-expansion of executive compensation." McDonough suggested that the "policy of vastly increasing executive compensation" was the result of bad morals. Average workers share McDonough's outrage. A recent Harris Poll of 2,023 adults found that the vast majority--87 percent of the respondents--believe that executives "had gotten rich at the expense of ordinary workers." Within that group, 85 percent reported they were angry with executive managers, 87 percent felt that top executives receive more than they deserve, and 66 percent indicated that workplace rewards were distributed less fairly than they were five years ago.

    The SEC is weighing proposed rule changes from the New York Stock Exchange and NASDAQ that would likely alter the way public companies use stock options and, consequently, how they pay their executives. Compensation committees under pressure from disappointed shareholders, employees resentful of soaring CEO pay, and looming regulatory changes will result in more time, effort, and resources being devoted to executive compensation planning.

    This presents human resources leaders with a unique opportunity to step between compensation committees and top management to negotiate executive compensation packages that address concerns about excessive pay while sufficiently rewarding CEOs for performance. Executives who understand the impact of factors such as company performance, size, and the hiring landscape for new executives in their industry can share that information with members of compensation committees. They also can analyze the strength of the compensation benchmark studies that consultants assemble. A relationship between human resources leaders and compensation committees provides workforce management with an opportunity to assume a higher profile in the company.

    Jeffrey Bacher, vice president of executive compensation consulting for Aon Consulting in Philadelphia, says that executive compensation projects, which include putting together benchmark studies that corporate clients use to help set annual executive compensation levels, now require 300 hours to complete. Two years ago, he wrapped up similar assignments in 100 hours. "Compensation committees want to make sure they understand the implications of their decisions for the other shareholders," Bacher says. "They're taking a much stronger role in the whole decision-making process."

    That kind of heightened sensitivity to setting executive compensation will be reflected in future studies, which will likely show a decrease in average executive compensation in most industries in the United States. Current studies still reflect executive compensation levels and strategies more in line with the extended bull market than the subsequent recession and wobbly recovery.

    The Conference Board executive compensation study released in mid-November found that total compensation for CEOs in 2001 was higher in all 14 industry groups except telecommunications and trade-retail, which remained unchanged from 2000. Median total compensation for CEOs in the financial services industry in 2001 was just shy of $12 million. Median total compensation for CEOs in other industries was lower: $1.9 million for insurance chief executives, $1.6 million for energy CEOs, and $1.2 million for those in manufacturing.

    Gregory Hessel, a managing director in executive search firm Korn/Ferry International's Dallas office, says that executive compensation levels are significantly less in 2003 than they were 24 months ago. Some chief executives have responded to swooning stock prices and backlash against CEO pay levels by voluntarily reducing their base salaries and/or bonus compensation. Cisco CEO John Chambers, for example, cut his base salary from $323,319 in 2000 to $1 in 2001 and has forgone a cash bonus, which was $1 million in 2000. He also returned to the company an option grant of two million shares that he could have cashed in for as much as $14 million.

Responding to shareholders
    Charlie Tharp, professor of human resources at Rutgers University in New Brunswick, New Jersey, and the former top human resources executive at Bristol-Myers Squibb, says that "companies are incredibly responsive to signals that stakeholders send." He says the accounting scandals and the cases in which executives misused their stock-option grants by exercising them at highly suspicious times have generated a greater emphasis on stock ownership in executive compensation strategy. "With options, if the stock rises, you sell the option and you no longer have an equity stake in the company," he says. "If you want executives to focus on the enduring benefits of their decisions, owning stock can help accomplish that objective."

    GE responded to the clamor over Welch's retirement benefits in November, when his successor, Jeff Immelt, unveiled a sweeping set of corporate governance changes, including a new compensation committee requirement that senior executives hold a specified amount of GE stock. Immelt, for example, has three years to purchase and hold six times his base salary in company stock. Senior vice presidents have five years to accumulate four times their base salaries. At Bristol-Myers Squibb, Tharp was required to own five times the value of his base salary in company stock during his tenure. Bacher reports that more of Aon's client companies are considering similar moves. But he recommends that executive stock ownership requirements be tied to a share amount because the dollar amount could translate to an astronomical number of shares when the stock price hits lows.

    Under its new compensation committee charter, General Electric also established a new stock-option holding period for senior executives. Now they must hold proceeds they gain from exercising options in GE stock for at least one year, to avoid "any possible appearance of an incentive for senior management to seek to cause short-term increases in the price of GE shares in order to exercise stock options and sell the stock for unwarranted personal gains."

    The current debate over stock options often neglects a key point. In a new book, two of Tharp's Rutgers University colleagues, human resources management professors Joseph Blasi and Douglas Kruse, investigate the link between stock-option grants and shareholder returns. They conclude that companies that give a high percentage of stock options to their executive teams produce weaker shareholder returns than companies that distribute stock options more evenly among the highest-ranking and other employees.

    Bruce Ellig, author of The Complete Guide to Executive Compensation (McGraw-Hill, 2002) and Pfizer's former top human resources executive, emphasizes that stock options aren't inherently flawed. "It's that they have been misused," he says. Stock options are often a highly effective component of compensation packages at start-up and high-growth companies which tend to have less cash available for high salaries, he notes. They have also helped large companies, such as Microsoft, link individual performance--at points deeper in the organization and below the executive level--to corporate performance.

Golden opportunity
    For human resources executives, the issues that are the most demanding during the annual review of compensation include the pros and cons of stock options, the likelihood of new accounting rules, and compensation committee charters.

    "It's deplorable that a lot of publicly traded companies' compensation committees don't have somebody that at least knows a little bit about HR," says Brent Longnecker, president of Resources Consulting Group in Houston. He believes that too many committees do not question the information contained in the benchmark studies they use as a guide in setting or approving executive compensation. "Many surveys don't distinguish between low-performing companies and high-performing companies or between small companies and large companies," Longnecker says. "They just lump together CEOs within an industry. And if you base your CEO's salary on vague information like that, you could be ripping off the shareholders. The link between HR executives and their compensation committees for the most part is terrible."

By providing strong guidance on executive compensation, human resources leaders can parlay the trust gained in that relationship to greater involvement in other critical decisions.

    Ellig says that he can think of no better way to get face time with company executives than to be knowledgeable about the principles of executive compensation. "They don't really care an awful lot about other stuff that HR people do, but they do care a lot about executive comp." Rank-and-file benefits packages, performance-management processes, and recruiting tactics are not areas of direct interest to most executives. However, executive compensation, given its status as a hot-button issue with shareholders and the fact that it directly affects their own wallets, is of much greater importance to executives. By providing strong guidance on executive compensation, human resources leaders can parlay the trust gained in that relationship to greater involvement in other critical decisions.

    Despite the confusing accounting environment, the essential principles of executive compensation remain the same: align executive pay with long-term shareholder value and with key performance indicators. Those indicators include sales growth, improved profitability, customer satisfaction, innovation, market share, and efficiency gains. Tharp says human resources leaders "should have a well-developed point of view so they maintain credibility and integrity with the compensation committee." He believes that more compensation committees will turn to external executive compensation consultants for assistance in setting more prudent pay packages.

    Although consultants have received criticism from shareholders and other compensation experts, like Longnecker, Bacher says they're not the problem. "Consultants don't give huge compensation packages to executives," he says. Bacher now clearly communicates to his clients that he ultimately works for their shareholders. He's typically hired by the head of human resources at the direction of the CEO, but insists on meeting with the head of the compensation committee at the onset of an assignment. And Bacher says the question of who he works for is now the first issue that most board members want clarified before he begins his research.

Paychex and balances
    Paychex is a payroll, human resources, and benefits outsourcing provider with 7,400 employees and just under $1 billion in annual revenue. Will Kuchta, vice president of organizational development, hires an external executive compensation consultant each year and works closely with him. The two develop the formal benchmark report that the committee uses to arrive at the compensation packages. The report is then given to CEO B. Thomas Golisano.

    Throughout the year, Kuchta and the consultant regularly speak with the head of the compensation committee. He also runs the executive team's strategy-planning meetings, sometimes lends his expertise to product development, and makes sure every manager in his department has taken at least two accounting classes.

    This approach to compensation helps explain why Golisano was named most valuable CEO by Forbes magazine last year. The ranking is based on comparisons of six years of compensation to six years of shareholder return. Golisano, who earned $744,230 in base salary in 2002, does not receive stock options, although the four other top executives (each of whom earns a base salary of between $272,000 and $328,000) are eligible for stock option rewards if they achieve performance objectives. Neither Golisano nor his top executives listed in the company's proxy statement received a cash bonus in fiscal year 2002, although they guided the company to an 8 percent increase in profitability and a 32 percent increase in shareholder equity during the year.

    Kuchta says the company's compensation plan is "purposely extremely simple."  The plan includes a combination of base salary, cash bonus, and stock options, but tilts heavily toward base pay.

    "Because the top guy doesn't receive options, it distributes a lot of options among our other executives, senior managers, and managers," Kuchta says. "It's all about aligning the three masters: shareholders, clients, and employees."

    At Paychex, managers and employees undergo a compensation benchmarking analysis similar to the study Kuchta presents to the compensation board. That helps maintain a measured approach to compensation packages for executives, who not only don't have 24-hour access to a corporate jet, but don't even get their own parking spaces.

Workforce, February 2003, p. 30-34 -- Subscribe Now!

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