By Louis Lavelle With companies about to start treating stock options as an expense, many critics of sky-high executive pay had hoped that companies would begin curbing big option grants. And they did. Unfortunately it hasn't made a dent in the overall size of pay packages, which grew exponentially last year -- the result of strong profits and surging stock prices that inflated bonuses, option values, and long-term incentives.
Compensation consultants predict 2004 may turn out to be one of the best years in recent memory to be a CEO, with average pay increases expected to exceed 20%. According to the Standard & Poor's ExecuComp database of more than 500 pay packages awarded in 2004, the highest-paid executives are still pulling down eight-figure numbers and outsize hikes reminiscent of the late 1990s. Says New York pay consultant James F. Reda: "It's another year of big increases."
This year, BusinessWeek changed how it calculated annual compensation to take into account the impact of expensing. Instead of including the big windfalls many execs receive when they cash in options, the magazine used the widely respected Black-Scholes formula to value annual option grants. That eliminates many of the eye-popping $100 million-plus pay packages of the past, but big numbersowing largely to big option grantscontinue to be fairly common. In fact, the highest-paid chief executive for 2004so faris Lew Frankfort, CEO of Coach (COH). More than 90% of his $58.1 million package came in the form of stock options.
TENS OF MILLIONS. There are three main reasons why pay was up in 2004: chunky profits, rising stock prices, and the move to big grants of restricted stock, which can't be sold until it vests, usually over a period of years. An improved profit picture persuaded many boards to loosen purse strings, awarding large bonuses and long-term incentives. The prospect of expensing encouraged many boards to replace some options with large grants of restricted stock. While that resulted in smaller option grants, surging stock prices boosted the value of those grants.
At the same time, rising equity prices allowed many executives with large option stockpiles from previous years to cash them in, reaping massive windfalls. Frankfort of Coach, Lawrence J. Ellison of Oracle (ORCL), and Howard Solomon of Forest Labs (FRX) all exercised options last year for gains of tens of millions of dollars. Solomon's haul just from exercising options was a cool $90 million.
Numbers like those still grab headlines, but the princely sums boards paid to CEOs were, by and large, justified by performance in 2004, the result of packages that have become more closely tied to specific performance targets. At Cendant (CD), CEO Henry R. Silverman received a $15.2 million bonus based entirely on strong pretax income and earnings growth. At homebuilder Toll Brothers (TOL), where profits soared 57% last year, the formula used to determine the annual bonus for CEO and co-founder Robert I. Toll would have given him nearly $50 million -- a figure so steep that Toll and the board agreed to cut it by $19 million. Says Chief Financial Officer Joel Rassman: "Bob and the board both thought the number was too high. It was a fairness issue." But don't feel too sorry for Toll. He still was paid a total package of $36.4 million, an increase of 52%.
DEBATABLE POINT. Still, not everyone who got a big pay packet can point to stellar stock performance. At Deere (DE), CEO Robert W. Lane took home $12.6 million, a 61% increase over 2003 even though shareholder returns were flat, vs. a nearly 13% gain for its peers. Deere declined to comment, but the company, in its annual proxy statement, spells out that executive bonuses are based on operating income and return on assets, which both doubled in 2004.
At Honeywell (HON), CEO David M. Cote saw his pay increase 38%, to $17.4 million, from $12.6 million in 2003 -- even though net income declined 3%, and Honeywell shares trailed their peers for the year. Robert S. Timmerman, director of executive compensation, said Cote's pay is justified by the company's improved financial performance, including growth in earnings excluding the impact of extraordinary items.
A debatable point. In 2004, though, such seeming disconnects between pay and performance appear to be the exception rather than the rule. That's progress. If that trend were to continue, sky-high pay -- one of the last artifacts from an era of CEO imperialism -- could one day be consigned to the history books. Lavelle is Management editor for BusinessWeek in New York
with Michael Arndt in Chicago and Amy Barrett in Philadelphia