The issue of compensation for chief executives was muted in 2007 but the issue will heat up again in 2008, says George Paulin, CEO of Frederick W. Cook & Co., a leading compensation consultancy that works for 54 of the largest 250 companies in the U.S. One issue that will be hot is whether compensation consultants, whose advice is critical in helping boards make decisions, have inherent conflicts of interest, a subject that Paulin testified on before the House Committee on Oversight & Government Reform in early December. Here are edited excerpts from a recent conversation we had:
Why wasn't CEO compensation a bigger issue this past year?
There were several reasons. First, there was a lot of information in these new proxy statements, maybe too much. Second, the new proxies had only one year of information so it was difficult to compare year-to-year change as you could have in earlier years. Third, there seemed to be more focus on a few bad examples or abuses, such as the Robert Nardelli case at Home Depot (HD) or the Hank McKinnell case at Pfizer (PFE), than on general coverage of it.
In 2008 the proxies will have comparable yearly information, so will it be different this coming year?
Yes, users of financial statements will have a better ability to look at the changes in compensation in the same format as they did this year, so they'll have a basis for comparison when it comes to pay for performance. But there will still be confusion because of the way the information is presented in the summary compensation table.
The numbers for the big portion of CEO pay, which are the equity incentives or other long-term incentives, are not the values at the time the incentives were granted. They are numbers for the purposes of accounting. So the comparability of those numbers, and the ability to tie them to performance, is going to be very limited.
Isn't there a big difference between the real value of options when they're exercised in 5 or 10 years, vs. the value the accounting profession gives them in the first year they're awarded?
Say you've got a salary of $1 million, a bonus of $2 million, and $5 million of stock option grant values. Those options are valued as compensation in the year they're granted. But what's the right to buy shares at a fixed price for the next 10 years worth to you at the time I give you that right? The new proxy disclosure rules add to this confusion. They don't help people compare executive compensation packages, what they're worth, and how that relates to performance.
Of all the issues surrounding CEO compensation, what will be the hot-button issue in 2008?
The overall dollars. People just think this is too much money. That's No. 1. And No. 2 is the ancillary aspects of compensation—not the salary or bonus, but related areas such as million-dollar pensions, perks like personal use of aircraft being paid for by the shareholders when someone is making $20 million or $30 million a year, and severance packages of $100 million or $150 million or $200 million when essentially you're being asked to leave because you haven't performed.
What about the role of compensation consultants, as per your testimony at Representative Henry Waxman's (D-Calif.) hearing?
The process has been criticized along these lines: There's cronyism. The CEOs have their friends on the boards and sitting on the compensation committees are other CEOs. You take care of me, and I'll take care of you. And further, the consultants are part of this because they're selling pay surveys that have this self-ratcheting kind of effect: The median pay package is X this year, so let's put ourselves 5% above that and the next guy puts himself 5% above that median. It's sort of a cycle. The consultants have been conflicted by the fact that they're not just advising the compensation committees. They're doing other things.
They're the pension actuaries or the insurance brokers, or they're selling human resources outsourcing services. There's an economic conflict that creates the perception of bias.
How does this conflict of interest work, whether real or perceived?
There were articles in the newspaper about Verizon Communications (VZ), which is a good example. The articles were about the fact that Hewitt Associates (HEW), and I'm not being critical of them, was advising the compensation committee at Verizon on executive and CEO compensation for a couple of hundred thousands of dollars a year. They were also pension actuaries and providing human resources services for several million dollars a year. The question is whether that creates a business conflict.
The implication is what? That if I'm getting millions of dollars from management, I'm going to recommend to the board that management gets paid more money than they should?
That's at least what's implied. I'm not saying that in my own experience I've seen that. It could be a perceived problem as much as a real problem. But clearly the potential for economic conflict is there. The revenues from these other services are so much more financially lucrative than the revenues from the pure consulting on executive compensation.
But you decline to do anything other than compensation consulting for a company?
Mercer Human Resources Consulting is part of Marsh & McLennan (MMC), the biggest insurance brokerage in the world. Towers Perrin is an actuarial firm primarily, and they provide other services related to human resources. Hewitt and Wyatt (WYT) are the same way. They are our major competitors. Our firm is a boutique. We don't provide any other services. Just basic economics says there is an inherent conflict if these other services are potentially so much more lucrative.
Are compensation committees, which have had reputations as being soft, getting stronger?
As a direct participant in this process, who goes to probably 150 compensation committee meetings a year whether on the phone or in person, I think the amount of progress that has been made since the Sarbanes-Oxley Act of 2002 has been monumental.
Does more progress need to be made?
Is it a perfect process? I think it varies from company to company. Big public companies that have a significant investment from institutional investors are aware of the governance issues surrounding executive compensation and are taking it extremely seriously. Are there still outliers? Yes. Are there still legacy practices, in which companies have legal obligations from agreements that were entered into in the past? Yes. Will the business community continue to provide bad examples? Yes. Are the dollars still high? Yes.
In the past, compensation committees were criticized for making disjointed decisions about salary at one meeting, then bonuses at another meeting, and retirement packages at still another. They lacked a full picture of what they were doing. Is that changing?
Certainly in all the cases where I'm involved, they've got that information. They have these so-called tally sheets. They're not just looking at the value of this year's compensation. They're looking at what's out there in outstanding unexercised options, unvested restricted stock, how much value was added to your pension plan, and if you have a company car and driver, how much did that cost? This is all on the table at these meetings. It's a much-improved process over five years ago.
As a result, will average CEO compensation go up or down in 2008?
It'll probably be flat to a slight increase in terms of grant value. Is there some significant adjustment in the economic value of these executives as reflected in their compensation packages? The answer is no. But you do see a lot of companies cutting back on severance and perks where there's not a business justification. Some of the abuses in those areas are going to be addressed.