Executive Pay: The Party Ain't Over Yet

An unusual thing happened in the boardroom at Kmart Corp. last year. Directors on the compensation committee brought in their own consultant to study the pay of Chief Executive Joseph E. Antonini and his top management team.

It's not that the directors necessarily thought Antonini, who earned $2.1 million last year, was getting too much. Rather, they wanted an outside perspective from someone who hadn't been hired by the chief executive or his human-resources department. "We just felt the need to have an independent view to make sure we were on the right track," says Joseph P. Flannery, who heads the committee. True, Flannery says, bringing in a consultant could make the CEO wonder if his directors really trust him and his advisers. "But I think it is a good thing to do."

PREEMPTIVE STRIKE. It may finally be happening: The mounting controversy over the growing paychecks of America's CEOs--not to mention the finger-pointing at complacent directors--seems to be goading many boards into action. Directors are devoting more time to the issue of compensation, often challenging the assumptions that lie behind the pay packages, demanding that they be linked to performance, and, as at Kmart, hiring outside consultants. Some boards, consultants say, have even eliminated stock-option grants this year, while many others have cut the size of such awards.

The reforms surfacing in the nation's boardrooms are partly the result of prodding by activist shareholders, who have been protesting the pay practices at companies ranging from Travelers to Martin Marietta and Pacific Telesis. They're also a preemptive measure taken by Corporate America that comes in response to threats from Washington of intervention in executive pay. And new disclosure rules imposed this year by the Securities & Exchange Commission have cast a spotlight that has spurred the reform moves on. "If the objective was to curb abuses in the marketplace, executive-pay disclosure is working," says Peter T. Chingos of KMPG Peat Marwick. "I am seeing a level of scrutiny and attention to detail I have not seen in my 22 years of consulting."

It sounds like a triumph of information over secrecy, of boardroom independence over cronyism, of private corporate governance over the heavy hand of regulation. Reform is indeed in the air--but don't look to BUSINESS WEEK's 43rd annual compensation survey for evidence of that. The figures here are bigger than ever. Thanks to extraordinary exercising of stock options--much of it sparked by President Bill Clinton's vow to hike personal and corporate income taxes--the average CEO of a big U.S. corporation pulled down a record $3,842,247 in total pay last year. That's 56% more than in the previous year.

Just to make it to the Top 10 list this year, a chief executive had to haul in more than $22.8 million. Only a few years ago, that would have been enough to capture the top slot. But the stock-option spiral of the 1980s has forced the numbers numbingly higher and higher. "The first couple of times CEOs cashed in their stock options and made $5 million or more, people were shocked," says Margaret M. Blair, an economist at the Brookings Institution who has been following corporate-governance issues. "The next year or so, $10 million wasn't enough, and 20 different people seemed to make that much. It now takes $50 million or $100 million to surprise anybody."

HEAVY WINDFALL. So, surprise: Topping the sweepstakes last year was Thomas F. Frist Jr., chairman and chief executive of HCA-Hospital Corp. of America, who brought in $127 million. The vast majority of that came from stock options Frist received when he led a leveraged buyout of his Nashville health-care conglomerate in 1989. The company went public again early last year, producing his windfall--and a tax payment to the Internal Revenue Service of $39 million.

And surprise again: Frist is already looking like a piker. In early November, Michael D. Eisner of Walt Disney Co. realized a stunning $197 million gain on stock options. That will almost certainly propel him to the top of next year's pay list. But because he exercised the options after the end of Disney's fiscal year, BUSINESS WEEK did not include them in his 1992 pay.

And just to err on the side of caution, let's call Frist's package an anomaly and exclude it from the 1992 averages, too. Even then, the total pay for the average CEO of a large U.S. corporation reached $3,494,296--a sizable 42% increase from the previous year.

For all the politically correct noises being made in the boardroom, the gap between the executive suite and the shop floor continues to widen, too. Last year, the average CEO made 157 times what a factory employee got. Back in 1980, when the chief executive's average paycheck was only $624,996, his total compensation was a mere 42 times the pay of the ordinary factory worker. In Japan, where corporate chieftains are paid much less, the CEO makes less than 32 times as much as a rank-and-file employee. "There have been abuses," admits Flannery, the Kmart director and former chairman of Uniroyal Inc. who also sits on the compensation committees of Scotts, Ingersoll-Rand, and Newmont Mining. "But I don't think those cases reflect the average situation," he says.

The BUSINESS WEEK survey, which was compiled with Standard & Poor's Compustat Services Inc., examines the pay of the two highest-paid executives at 365 of the largest U.S. corporations, defined by market value. A total of 467 of these 730 executives earned more than $1 million last year. Among the standouts were Sanford I. Weill of Primerica, who collected $67.6 million; Charles Lazarus of Toys `R' Us, who received $64.2 million; U.S. Surgical's Leon C. Hirsch, who got $62.2 million; and Chrysler's former chairman, Lee A. Iacocca, who picked up $16.9 million on his way out the door. The winner among the non-CEOs surveyed was Donald R. Keough, who retired on Apr. 15 from being president of Coca-Cola Co. He earned $40.8 million.

Most such packages came in the form of stock options, as directors continue to shift more compensation away from salary and short-term bonus. Frist, for example, made a mere $1,068,000 in salary and bonus; Weill just $2,752,000. A recent decision by the FinancialAccounting Standards Board requiring companies to charge options against earnings may slow that shift--but the change won't take effect for three years, if ever. In the meantime, options grants keep swelling, while other forms of compensation actually shrink. Indeed, for the second straight year, the CEO's average salary and bonus went south, falling about 2%, to $1,104,769, according to BUSINESS WEEK's Executive Pay Scoreboard. That decline in base pay came in a year when corporate profits rose by 22%.

So it's small wonder, then, that many executives would rather you saw their salary and short-term bonus as the sole components of a current year's compensation figure. They argue that it is unfair to lump option gains, which result from the exercise of stock options granted as long as a decade ago, into a single year's pay. The seemingly lavish profits, they say, are one-time rewards for many years of work, and they come only when shareholders benefit from significant appreciation in the value of the stock. But the list contains a good number of familiar faces, executives who have become perennial winners in the pay game. Their reappearance on the best-paid list year after year suggests that, for some CEOs, large stock-option gains are hardly an unusual event. This year's No.2, Primerica Corp.'s Weill, for example, was No.6 last year, with $15.9 million. H.J. Heinz Co.'s Anthony J.F. O'Reilly, No.5 this year, with $36.9 million, was last year's No.1, with $75 million. And Torchmark Corp.'s Ronald K. Richey, who is now No.9 with $26.6 million, made the Top 10 list just four years ago.

As for the notion that stock options mean that CEOs profit only when shareholders do--well, the timing is everything. Hirsch of U.S. Surgical netted $60.4 million by exercising his options last year and by selling his company's stock--at prices that ranged from $65 to $120. The current shareholders may envy him: U.S. Surgical's stock plummeted 46%, to $30, in just the first two weeks of April.

ASTERISKED? On the other hand, some shareholders had reason to applaud their CEO. At the low end of the pay sweepstakes, for example, you'll find Novell Inc.'s Raymond J. Noorda, who made only $198,830 last year. That puny paycheck, along with superlative results, allowed the software CEO to come out on top of BUSINESS WEEK's pay-for-performance analysis. Dollar-for-dollar over the past three years, he delivered the highest return to shareholders and produced the best company results. Who delivered least? Heinz's O'Reilly and Digital Equipment's former Chairman Kenneth H. Olsen.

And what did this year's No.1 do to earn his $127 million? To hear HCA's Frist tell it, his record compensation--like Roger Maris' home-run record for years--should have an asterisk next to it. Under his management, HCA had grown by the mid-1980s into an unwieldy health-care conglomerate that owned or managed 486 hospitals around the world, with interests in insurance companies and health-maintenance organizations. Frist maintains that he couldn't have restructured his company to focus on its core hospital group without risking a takeover bid from a raider in the predatory 1980s, so he took it private in a leveraged buyout.

His investors--including J.P. Morgan, Goldman Sachs, and Texas financier Richard E. Rainwater--agreed to give Frist and more than 700 other managers options to buy 26 million shares of stock in the company at prices as low as 22.7 a share. By the time the company was ready to go public again, in March of 1992, at $21.50 per share, HCA had been slimmed down to a collection of 74 medical-surgical hospitals and 54 psychiatric hospitals. The $300 million worth of LBO equity--$33.2 million of which was contributed by Frist and his family--had been transformed into shares and options with a value of $2.83 billion--a payback of 9-to-1 in only three years. "HCA is the most successful LBO of the 1980s," Frist says. "This is an unusual situation, where a home run was hit and everyone was a winner."

His investors seem to agree. Rainwater believes Frist deserved every penny. "You've got to remember that Tommy Frist put his entire family fortune at risk," he says. "I believe rewards should go to people willing to take risks." Rainwater worries that the outcry over soaring compensation could suppress such risk-taking. He thinks directors, the ones best suited to tell company-builders from company-trashers, should become more activist. "That's where the governance ought to be: at the board level, not in Washington," says Rainwater.

Despite the stratospheric numbers, it's clear that boards are taking a tougher line. At one company after another, pay consultants are finding directors more willing to question CEO pay packages. The decision by Kmart's directors to seek an outside opinion--which, as it turned out, did not lead to significant changes in pay practices at the huge retailer--was repeated by panels at many companies last year. Chingos of Peat Marwick estimates that half his assignments in the past year were directly for compensation committees of boards. Three years ago, just 1 in 10 of his consulting jobs was for board directors.

That was when the process of setting CEO pay was a study in clubby cronyism. The CEO or his top human-resource official would decide which consultant to hire and what the consultant would study. The report--often a survey of what competitors paid their executives--would then be presented to the compensation committee as justification for a fatter package for the boss. The CEO was often present in the room as directors discussed and set his pay. It took just a cozy, informal, relatively brief session or two to rubber-stamp the compensation for the CEO and his senior managers.

Now, it's becoming a more rigorous process, requiring several committee meetings. "Directors are now asking for pay information well in advance," Chingos says. "They want all the backup data, including what companies are being used for comparisons. And they want time with the consultant alone." Adds Donald S. Perkins, a director at American Telephone & Telegraph Co. and several other leading corporations: "In many cases, the process of reviewing the compensation of the CEO is now more formal and more explicit. We're spending more time reviewing the CEO's goals at the beginning of a year and measuring his progress at the end."

Inside every boardroom, the key issue is how best to link pay to performance. The standard solution is the stock option, but a number of more rigorous committees are beginning to wonder if it's the right answer. The reason harks back to the old Wall Street saw about not confusing brains with a bull market. Options, by rewarding CEOs whose stock rises along with the tide, may be doing just that.

HIGHER HURDLE. Some companies, such as AT&T and Colgate-Palmolive Co., have acknowledged as much by pricing the options at a premium. This year, for instance, Colgate awarded Chairman Reuben Mark the options to buy 1 million shares of stock. The largest single chunk of those options, 400,000, carries an exercise price of $100.35 per share--even though the stock now is trading at about $60. So Colgate's price must rise by two-thirds before Mark even begins to enjoy his work's larger incentives.

That strategy ensures that the shareholders will realize stock gains before the chief executive does. But it still doesn't go as far as some pay experts advocate. Some believe that the strike price of options should be adjusted for a rise or fall in the stock market. "Simply rewarding an executive for the upward drift of the overall market makes no sense," says Robert H. Topel, an economist at the University of Chicago. "It's no different from just giving him the shares outright."

Such talk by critics of executive-pay practices is nothing new. What's different is that boards of directors are listening--and acting. You may not be able to prove it by this year's numbers, but the times, they are a-changing.