For George David, the brainy chief executive of the old-line industrial conglomerate United Technologies Corp., (UTX ) 2004 was another winning year. UTC racked up an 18% gain in net income, to $2.8 billion, on 21% higher sales of $37.4 billion. Shareholder returns of 11% were nothing to sneeze at, matching the Standard & Poor's 500-stock index. So did UTC's board shovel on the goodies when pay day came around? Not exactly. Sure, David's bonus rose, to $3.5 million from $2.8 million. But his grant of stock options actually shrank. In fact, it was only the rise in UTC's share price -- reflected in an $8.6 million valuation for those grants -- that enabled the CEO to record a 16% raise in total pay for the year, to $13.6 million.
In a year when profits and stock prices surged, rewards for CEOs such as David were generous. But BusinessWeek's 55th annual Executive Pay Scoreboard found that increases were moderated in 2004 by the continued impact of corporate reform, an ongoing shareholder revolt over astronomical pay levels, and pending accounting changes that are reining in the use of stock options. Our survey of 367 CEO pay packages showed that:
-- Total CEO pay was up smartly, to an average $9.6 million -- a 15% increase from $8.3 million in 2003. But that average was skewed by the outsize pay package of our most highly compensated CEO, Yahoo! Inc.'s (YHOO ) Terry Semel, who received a package worth $120 million made up almost entirely of options. Take him out of the mix and the average raise was 11.3%, not far off the rise in shareholder gains: The S&P 500-stock index increased 10.9%. CEOs of the nation's biggest companies by market capitalization took home a total $3.5 billion in salaries, bonuses, and long-term compensation, including the value of 2004 option grants. Nearly two out of three CEOs saw their pay go up last year, with overall cash compensation rising 13.6% and long-term compensation increasing 15.6%.
-- CEO raises and total pay once again dwarfed those of the average worker, who saw pay rise 2.9%, to $33,176 per year. Nearly 40 of the nation's chief executives walked away with more than $20 million, excluding windfalls from option exercises.
-- There have been improvements, but pay for performance is still not the standard practice everywhere. Some boards, at least, are still lavishly rewarding CEOs who deserve far less. At Blockbuster Inc. (BBI ), for example, where operating income fell by nearly 50% and shares plunged by 47%, CEO John F. Antioco's pay increased 541%, to $56.8 million. One reason: The board replaced 4.3 million of his mostly underwater options with 1.6 million shares of restricted stock worth $14.7 million as a "retention measure." That enraged governance experts, who called it a bailout for a CEO whose lackluster performance has destroyed billions in shareholder value in the past three years. The company says operating income was down due to a $250 million investment in new initiatives, and says the stock was hurt by uncertainty over Viacom Inc.'s (VIA )80% stake in the company, which it sold to the public in October. Says Blockbuster Chief Financial Officer Larry Zine: "We think we actually performed pretty well."
Elsewhere, pay and performance seemed better aligned. Tyco International Inc.'s (TYC ) Edward D. Breen Jr. landed a $23.2 million package, up from $3.7 million in 2003, for continuing his two-year turnaround of the once-troubled conglomerate. Sales were up 11%, profits nearly tripled, and Tyco shares ended the year up 50%.
Pay anomalies are now easier to detect, thanks to a new methodology that BusinessWeek began using this year. Instead of counting the windfalls from option exercises as part of the annual pay package, as we have in the past, we're counting the value of annual option grants. The values are calculated using the Black-Scholes formula by Standard & Poor's, which like BusinessWeek is a division of The McGraw-Hill Companies. (MHP )
Our new formula also recognizes the new accounting reality of expensing, which requires companies to determine the value of options when granted and to deduct that amount from profits over a period of years. To standardize the Black-Scholes calculations, S&P uses standard inputs such as volatility, along with details of each option grant, including the exercise price. As a result, the option values used in BusinessWeek's pay calculations may not match those disclosed by the companies.
Counting options at the time they're granted instead of when they're exercised results in some dramatic changes. Under the old formula, a CEO who exercised a big slug of long-held options could have catapulted to the top of our rankings -- even though that windfall represented stock gains accumulated over many years. UTC's David, for example, exercised 1.1 million options for an $83 million gain last year. Semel, meanwhile, cashed in more than 10 million options for $230 million in 2004. With windfalls like those, both would have been at or near the top of our ranking using the old methodology. Semel still landed at the top of our pay scoreboard this year, thanks to new, gargantuan option grants. But David, with a total compensation of $13.6 million, wasn't anywhere close to the top.
Eliminating those windfalls allows us to make more precise long-term comparisons. What we found when we compared the pay packages of today with the pay of CEOs from the late 1990s, using the same methodology, was enlightening. While the conventional wisdom holds that CEOs are getting more egregiously overpaid each year, in fact the truth is more complicated.
Consider Semel. His $120 million payday made him the highest-paid chief executive in the BusinessWeek scoreboard. True, Semel's performance last year was outstanding, as Yahoo doubled sales, increased profits 253%, and delivered shareholder returns of 67%. Yet Semel's reward makes him even more overpaid than some of the biggest earning CEOs of the boom years. His compensation far exceeds the average pay packages of IBM's (IBM ) Louis V. Gerstner Jr. ($42.6 million), Cisco Systems' (CSCO ) John T. Chambers ($52.1 million), and General Electric's (GE ) John F. "Jack" Welch ($64 million) during that period -- each of whom ran far larger companies. Yahoo declined to comment. But the compensation committee, in the annual proxy, notes that Semel's skills "make him an attractive candidate to competing organizations."
Even so, mega-payouts are a lot less common today. Sure, most workers would be glad to get an 11.3% raise -- the average CEO increase without Semel -- but it doesn't seem wildly excessive for a CEO who adds real value. The new restraint has a lot to do with the market correction of 2000 and the shareholder revolt against big pay packages that followed. In some cases, late-'90s pay packages ballooned because option values were inflated by unrealistic stock prices. Both former Tyco CEO L. Dennis Kozlowski and former Computer Associates chief Charles B. Wang, for example, received massive option grants just as those stocks were approaching all-time highs.
At the same time, many longtime CEOs, like Oracle Corp. (ORCL ) chief Lawrence J. Ellison, had options awarded many years earlier that could still be cashed in for huge profits, even after the market tanked. In 2001, Ellison cashed in 23 million options for a $706 million gain. Ellison's payday was the largest ever, but he was hardly the only CEO who reaped improbably large rewards while regular investors watched their own portfolios evaporate. The resulting backlash prodded many boards to make changes. Among them: fewer options, more restricted stock, and tougher performance hurdles. Those changes, along with lower post-crash equity prices, brought many pay packages back to earth.
But those changes won't mean the end of huge option windfalls. The fact is that option stockpiles are now so big that, if prudently managed, many CEOs will be able to continue extracting sizable annual option windfalls from them for the foreseeable future. Only a handful of companies, like Microsoft Corp., (MSFT ) have gone cold turkey and stopped granting options. At those companies option stockpiles will be exhausted in a decade or less, since most options expire after 10 years. In 2004 the 200 big companies tracked by New York pay consultants Pearl Meyer & Partners granted options equal to 2% of their outstanding shares, down from 2.7% in 2001. CEOs saw the stock option portion of their pay packages decline from 51% to 37% in just one year -- in part because grants of restricted stock increased.
But the vast majority of companies continue to partially replenish executive option stockpiles. In 2004, for example, Richard D. Fairbank of Capital One Financial Corp. (COF ) exercised more than a million options for a take-home total of $56.5 million -- and the board granted him 566,000 new options with a value of more than $25 million. With more than 11 million options worth $560 million in his stockpile, Fairbank can continue making withdrawals and deposits at that rate almost indefinitely. Fairbank's 2004 option grant was much larger than his 2003 grant, at a time when the company cut back on all option grants by nearly 60%. But as the board's compensation committee notes in the annual proxy statement, Fairbank did not receive a restricted stock grant in 2004, and he has waived his salary and bonus since 2002.
It will be a long time before execs burn off those option piles. For a hint of things to come, look at the option-exercising binge some CEOs went on in 2004. Lew Frankfort, CEO of trendy leather goods maker Coach Inc. (COH ), exercised options worth $84 million, on top of his $58.7 million pay package. Coach Chief Financial Officer Michael F. Devine III says Frankfort earned every penny of his paycheck: "He has created $10 billion of shareholder value. I would take a $10 billion return on a $50 million investment any day." Still, critics of inflated CEO compensation will find plenty of ammunition for years to come.
By Louis Lavelle in New York, with bureau reports