A top consultant explains how CEO compensation has gotten out of hand and how to fix the problem without sacrificing an important executive incentive
Boards of directors must quicken their pace in coming to grips with compensation for chief executive officers or risk losing control of their companies to a chorus of shareholder activist critics, says Pearl Meyer, a leading compensation consultant at Steven Hall & Partners in New York. But they should resist efforts to link annual CEO compensation to the company's share price, and the Securities & Exchange Commission has more work to do on the issue, she adds. Here are edited excerpts from a recent conversation:
What's at stake in the fight over CEO compensation?
Our boards of directors are being challenged by investors along with special interest groups as well as academics, legislators, and regulators. They are seeking a power shift in the governance of the corporation. Unfortunately, executive compensation is being used as a wedge issue by these groups to assert influence and control over the corporation in pursuit of their own agendas. Many of these special interest groups have objectives with which we agree. They include the union and government pension funds endeavoring to protect the pensions of their members. Other activists are trying to protect the environment and effect social change. But in addition to these groups, we have the hedge funds, private equity funds, and short-term investors seeking healthy gains. The way they're getting in is by protesting something that is very obvious, which is executive compensation.
Are boards getting smarter about how they manage CEO compensation?
Over the past several years, we've gone from the imperial CEO and the passive board to a proactive board which is now comprised almost totally of independent directors, who have independent outside counsel from firms such as ourselves advising them on pay for performance and marketplace comparability, as well as internal performance parameters. The environment has changed totally over the past five to seven years.
Has one issue been that compensation committees did not really have a firm grip on all the elements of the pay packages they were granting top management?
That's quite right. In prior years, the responsibility for benefits and perquisites was confined to people within the corporation. Executive compensation, meaning direct pay, which is salary and bonus, and incentives such as equity participation, came under the purview of the executive compensation consultant, meaning people like myself, who worked with managements and the boards. Now we report solely to the compensation committee and bring together the total tally of remuneration. Before, there were two separate pieces and nobody added it all up together.
In other words, boards didn't really know what they were doing?
They did, but there were two or three separate pieces. But they didn't really add it up together until the past few years because of tradition—that was always the way it was done.
Are we going to see a flattening out in the rate of increase in CEO compensation?
I don't know. It's a function of performance with respect to profitability; returns; shareholder value, of course; and the marketplace for executive talent. If a company's performance dropped, like Merrill Lynch (MER), which just reported a steep decline in earnings, while Goldman Sachs (GS) and Lehman Brothers (LEH) reported higher earnings, one would expect Goldman Sachs and Lehman executives to show increases in their compensation. We might expect to see Merrill Lynch's down.
How can you fix the problem of CEOs appearing to be richly rewarded when the performance of their company is off, as was the case for Robert Nardelli at Home Depot (HD) (BusinessWeek, 01/03/07) and Hank McKinnell at Pfizer (PFE) (BusinessWeek, 12/22/06)?
They were both paid large amounts, perhaps excessively large, and situations like that need to be cured.
In some cases, CEOs are making 5- or 10-year bets, as Verizon Communications' (VZ) CEO Ivan Seidenberg is doing with optical fiber to the home. Without really knowing how the bet will play out, how can a board set compensation in these kinds of cases?
You have to remember that when the analysts and mutual funds assess performance, they themselves are being paid based on a very short term. Their interest is short-term—the average mutual fund holds equity in the average corporation for 11 or 14 months. There is tension in the system, with the media and the short-term investors being concerned about how the stock did for one year, whereas the board and management have to make sure the companies are healthy over the long term and you may not see the results for a few years.
Has one problem been that compensation committees have not had a grasp on financial results and haven't been linked enough to the audit committee, where the results are clear to see?
No, there generally is linkage, at least at the chair level. The chair of the compensation committee generally consults with the chairs of the audit and governance committees to get a qualitative evaluation of senior management's performance as well as the numbers. Their perspective cannot be based solely on the short-term return to shareholders.
Did something go wrong in the overall CEO compensation system?
I believe that at certain companies, certain elements of pay went too high. Companies went too far in the use of mega-option grants. For many years, they gave out options like they had no value. They have gone too far on severance (BusinessWeek 03/22/07) and change-of-control protection. There are corrections to be made in the system that are being addressed. Avaya (AV) eliminated the tax breaks on aircraft for management. ExxonMobil (XOM) eliminated club memberships. American Express (AXP) reduced its Supplementary Executive Retirement Program (SERP).
But it's critical to preserve the core of our executive compensation system, which is incentives. Without incentives, companies will be unable to attract the talent they need and to grow their businesses, and that is what has made America the world's No. 1 nation.
How do you respond to the criticism that some compensation consultants were consulting for management on other issues and therefore had a conflict of interest when it came to advising boards on management's compensation? Was that part of what went wrong?
I don't really believe so. The appearance, perhaps, led people to that conclusion. The large firms that render accounting and actuarial, benefits, and compensation services—or ABC firms—include the major accounting firms and major actuarial firms such as Towers Perrin and Hewitt (HEW). These services are big-ticket items, whereas executive compensation is small-ticket. The feeling was that if a firm was rendering all these other services, they would not appropriately police or advise the compensation committee and board on senior executive pay. Our firm has confined itself solely to executive and board compensation. We've never had a conflict. I do know the people in the large ABC firms and I've never had reason to question their integrity. But appearances being what they are, we'd be better off not having a firm render both types of services.
And what has been the practical impact of the SEC's new rules on executive compensation?
It's had a great deal of impact. Their intent was appropriate. The execution has not been with regard to the way the SEC framed the rules and because of the confusion, the response has not been all that it should have been. So the SEC has been issuing letters to companies, asking for additional information and detail. But I think they have to clarify the rules.
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