Suggest to Edward W. Barnholt, CEO of Agilent Technologies Inc. (A), that his company had a less-than-stellar 2002, and you'll get little argument. After spinning off from Hewlett-Packard Co. in 1999, just as the dot-com bubble was stretching thin, Barnholt has seen the $6 billion Silicon Valley tech company laid low. In 2002, sales were down 28%, the stock was off 35%, and Agilent posted a $1 billion loss.
So when it came time for the board to decide Barnholt's pay, he paid dearly, with a 10% cut in his base salary, to $925,000, and no bonus or restricted-stock grant for the second consecutive year. His old options weren't much use, either. The 750,000 options that he received last year have been underwater almost since the moment they were granted. Says Barnholt: "I don't expect anything different. If the company doesn't perform, I shouldn't be getting any rewards."
Stories like Barnholt's mark a shift in the way reward and punishment are meted out at the highest levels in Corporate America. Pay for top chieftains declined by double digits for the second year in a row in 2002, the result of a brutal bear market that gutted much of their option wealth and robbed many of seven-figure bonuses. The result: CEO pay is back to where it was in 1996. Pay packages in 2002 declined 33%, to $7.4 million on average, according to BusinessWeek's 53rd annual Executive Pay Scoreboard, compiled with Standard & Poor's ExecuComp. "There's no question: Compensation committees are taking a very hard look at the compensation of senior executives," says Dan L. Goldwasser, a member of the pay panel at Forest Laboratories Inc. (FRX) Longtime Forest CEO Howard Solomon receives only a modest salary despite outstanding performance, though a surging stock helped him to realize big gains in 2001 when he exercised options.
Of course, averages can be deceptive. What has really been wrung out of the system is the excess at the very top of the scale. In last year's ranking, Oracle Corp. (ORCL) CEO Lawrence J. Ellison set a record with a $706.1 million payday after he exercised a big stash of options. This year, the highest-paid exec clocked in at just $194.9 million. Last year, the top seven execs on our pay scoreboard broke the $100 million barrier; this year, only two did. The numbers were also skewed by a handful of CEOs who, in light of weak performance and a backlash against obscene pay, elected to work for nominal sums or who gave back part of their take. So while average exec pay plunged by a third, the median pay for our 365 CEOs actually rose by 5.9%, to $3.7 million. Yes, it's an increase, but not to a level that's apt to provoke investor outrage.
With the most gargantuan pay packages scaled back, some observers believe the rules have changed and imperial pay will no longer be tolerated. That's not to say that pay for performance has been embraced everywhere. Even with the declines of the past two years, CEOs still earn more than 200 times as much as the average worker. But compensation experts say that future increases are likely to be far smaller, even if a 1990s-style bull market were to return, as governance, accounting, and compensation changes now in the works exert downward pressure on pay. Says New York pay consultant Pearl Meyer: "The golden era in executive compensation is over."
That's largely because of a new conservatism among directors. Knowing they will have to justify their compensation decisions, many boards are starting to reserve the big bucks for executives who deliver outstanding performance. Questionable practices, such as repricing underwater options or doubling up on option grants when the company stock falls, have become much less common. "Directors are really of a different frame of mind these days," Jack Dolmat-Connell, senior vice- president for executive compensation at Clark/Bardes Consulting. "I haven't seen any going out on a limb in any way, shape, or form in the last six months. I just think they're scared to death."
What's more, the large equity stakes held by most chief executives have shrunk in value, in step with the stock market. During the 1990s, stock and options became an increasingly important component of CEO pay. To measure the impact, BusinessWeek last year began tracking changes in pay-related wealth, which includes the value of all vested and unvested stock options and options exercised during the year, plus base salary, bonus, and restricted stock grants. In 2002, as stocks plummeted, average pay-related wealth for the CEOs in the BusinessWeek scoreboard followed suit, declining by 43% to $21.8 million.
The decline in executive wealth is likely to be felt for some time to come. Most of their low-priced options have been exercised, and a lot of those that remain -- 40%, by one estimate -- are now so far underwater that they will probably expire unexercised. Boards are unlikely to replenish the stockpiles as quickly as they did in the past. With increased investor scrutiny and the possibility that Congress may force companies to account for the cost of options on their income statements, the trend is decidedly toward smaller grants. Ira Kay, compensation practice director at Watson Wyatt Worldwide, says that if accounting regulators require companies to count options as an expense, executive pay in coming years will grow by less than 10%, compared with the 38% annual growth of the late 1990s.
Even in a down year, though, it's hard to weep for CEOs. Many still managed to haul in monumental pay in 2002. At the very top of the pay pyramid was Alfred Lerner, the former CEO of MBNA Corp. (KRB) who died in October. He exercised options for a $194.9 million bonanza, making him the highest-paid CEO on our scoreboard. Some of the other highest-paid execs managed the feat even though they or their companies are mired in scandal. No. 2 Jeffrey C. Barbakow at Tenet Healthcare Corp. (THC) -- a company facing multiple federal probes, including one focusing on Medicare billing -- exercised options for a $111.1 million gain. A Tenet spokesman said many of the options were granted nine years ago, and counting their exercise as 2002 pay is misleading. Tyco International Ltd.'s (TYC) disgraced CEO, L. Dennis Kozlowski, took home $71 million before his departure and indictment on charges of sales-tax evasion. The bulk of Kozlowski's pay was $67 million in restricted stock. The company says it is seeking to recoup all of Kozlowski's pay.
For some CEOs, though, 2002 was a year of rough justice, as bonuses and options fell victim to poor performance. For the second consecutive year, more than 40% of the CEOs in the BusinessWeek scoreboard saw their total pay decrease. Plunging stock prices made it impossible for Richard D. Fairbank at Capital One Financial (COF), Michael D. Eisner at Walt Disney (DIS), or Carleton S. Fiorina at Hewlett-Packard (HPQ), among others, to exercise underwater options. Options weren't the only problem. Richard H. Brown at Electronic Data Systems (EDS), Sidney Taurel at Eli Lilly (LLY), and a host of other CEOs all lost their bonuses. Taurel volunteered to cut his pay to $1, citing the falloff in Prozac sales following patent expiration, and the board didn't give him anything else, save for 350,000 options that are now underwater. Says comp committee member Steven C. Beering: "We wanted to make a statement that we were really taking a hard-nosed approach to this."
Perhaps seeing the handwriting on the wall, other execs also gave back big chunks of their pay. Both John T. Chambers at Cisco Systems Inc. (CSCO) and Thomas M. Siebel at Siebel Systems Inc. (SEBL) waived rights to millions of stock options -- though many of them were underwater at the time. Even so, both Chambers and Siebel fared poorly in BusinessWeek's three-year pay-for-performance analysis, mainly due to big option exercises in earlier years and the pummeling of tech stocks over the last three years. IBM's (IBM) Samuel J. Palmisano got his board to cut his 2003 bonus and use it to provide performance-based rewards for 20 top executives. Says Palmisano: "If you say you're about a team, you have to be a team. You've got to walk the walk, right?"
Other CEOs collected modest comp packages despite outstanding performance. Many of them can be found on our list of executives who gave shareholders the best value for their pay. BusinessWeek's pay-for-performance analysis compares three years of pay -- base salary, bonuses, and long-term compensation, including exercised stock options -- with three calendar years of shareholder return. That methodology highlights the relationship between pay and performance, but it can also hurt longtime incumbents, even if they perform well. That's because most options expire after 10 years. As long-time CEOs exercise low-priced options issued years earlier, they stand to reap extra-large pay packages. Colgate-Palmolive Co.'s Reuben Mark, for example, has a strong record as CEO, but option exercises give him a low grade in pay for performance.
The CEO with the best shareholder return relative to pay was Richard D. Kinder, the billionaire co-founder of Kinder Morgan Inc. (KMI), who works for $1 a year and had a three-year total return of 113%. In the debate over whether top executives are overpaid, Kinder comes down firmly on the side of pay critics. "It's a tough job, and it should be well paid, but it got out of hand," says Kinder, who caps base salaries at the Houston energy company at $200,000 a year. "It's time to restore some rationality."
The CEO who delivered least for shareholders, for the second consecutive year, was Oracle's Ellison, whose massive 2001 haul, combined with a plunging stock price, virtually assured a poor pay-for-performance comparison. An Oracle spokesman said Ellison declined to comment.
Joining Ellison on the list were other execs who managed to reel in big bucks despite poor performance. Among them: Sun Microsystem's (SUNW) Scott McNealy. In three years, he hauled in $53.1 million, mostly through option exercises, while investors saw the value of their Sun shares decline by 92%. And McNealy's riches are likely to continue. In 2002, he was awarded 3.5 million options. They're under water now, but the company estimates they have a future value of $24 million. A Sun spokesman said that most of the options McNealy exercised in 2002 had lost the bulk of their value and were about to expire. McNealy, who takes only a $100,000 salary, kept most of the shares.
Many executives who fared poorly in our pay-for-performance analysis disputed our methodology. Some argued that including option exercises unfairly inflates pay amounts. Other execs said that it treated them as having cashed out, even if they held onto the shares. Stephen H. Clark at SpectraSite Inc., which recently emerged from bankruptcy, was paid $8.3 million despite shareholder returns of -99%. But CFO Dave P. Tomick says Clark lost more on the shares he acquired on option exercises than he gained in cash compensation. Says Tomick: "He went down with the shareholders."
Others on our list of CEOs who got the most for doing the least have weaker arguments. In some cases, rather than hold them to strict performance standards, their boards simply changed their definition of performance. At Cendant Corp. (CD), the comp committee changed the formula for CEO Henry R. Silverman's bonus, netting Silverman $7.9 million, or about $2.9 million more than he would have earned under the old formula. Silverman, who renegotiated his contract to eliminate his annual option grants starting in 2002, says the new formula is based on pretax income, which he says is "the best proxy for the health and profitability of the company." Although Apple Computer Inc. (AAPL) CEO Steven P. Jobs earns a salary of just $1 a year, he did get quite a bonus when the Apple board agreed on Mar. 19 to exchange 27.5 million of his underwater options for 5 million shares of restricted stock worth $72 million -- in effect rewarding him for the 80% slide in Apple shares over the past three years. Apple, which declined comment, has said the move was part of an effort to reduce its options overhang to 16%, from 23%, of outstanding shares.
So did two years of declining paychecks cut executive compensation to a reasonable level? By one measure, at least, it may have. Both the average pay for all CEOs and the average for the 20 highest-paid chief executives for 2002 are now, in inflation-adjusted terms, back to where they were in 1996, the year the real runup in executive pay began. And although $7.4 million, the average pay package for our scoreboard CEOs, is still a breathtaking amount of money, being the boss is a hard job. New York pay consultant Alan Johnson argues that the decreases of recent years -- combined with the increased complexity of the job and the risk CEOs take on with large undiversified holdings in their company's stock -- have resulted in pay levels that now roughly match the task at hand. Says Johnson: "Executives are more important than we used to believe. And the job is a lot harder and a lot riskier."
It's true: Expectations, both for performance and pay, have been reset in recent years, as corporate titans of a previous era are one by one caught in the recessionary downdraft. But that's not necessarily a bad thing. After all, if shareholders have to accept a new era of single-digit gains, it's only fair that CEOs readjust their expectations sharply downward as well. That's what pay for performance is all about.
Corrections and Clarifications
The accompanying .pdf file of the "Executive Compensation Scoreboard" includes
an erroneous footnote at the entry for Family Dollar Stores Inc. CEO Howard R. Levine. He did not leave the company on Jan. 16. His father, Leon Levine, retired on that date.
By Louis Lavelle in New York, with Frederick F. Jespersen and Spencer Ante in New York and Jim Kerstetter in San Mateo, Calif.