Special Report: Executive Pay

The numbers are staggering, but so is the performance of American business. So how closely are they linked?

Greed is good! Greed is Right! Greed works! Greed will save the USA!

--Michael Douglas, as Gordon Gekko in the film Wall Street

Money begets money.

--John Ray, English Proverbs, 1670

As the American Century draws to a close, times have rarely been better. Eight years into an expansion that just won't quit, the robust U.S. economy is the envy of the world. Growth in the gross domestic product continues to hum along at a rate of 4.3%. Thanks largely to a world-beating high-tech sector, and the willingness of American companies to quickly adopt whatever new technologies and new processes give them an edge, U.S. competitiveness may never have been higher. Unemployment is at a 29-year low, wages are rising, and consumer spending is soaring--all without a whiff of inflation. And the stock market--ah, yes, the U.S. stock market. With the Dow now hovering around 10,000, up 263% this decade, the U.S. equity markets have outrun, outgunned, and hands-down outperformed every other major stock market in the world.

That market has also made many people wildly wealthy, and none more so than chief executives at major U.S. companies. Thanks to a pay structure that has linked most executive compensation to the stock market through huge option grants, the head honcho at a large public company made an average $10.6 million last year. That's a 36% hike over 1997--and an astounding 442% increase over the average paycheck of $2 million pocketed in 1990. Yet even $10.6 million is chicken feed next to 1998's best paycheck. Walt Disney Co. CEO Michael D. Eisner took home $575.6 million--primarily from options--the second largest payday ever recorded by a public company CEO. Altogether, the five best-compensated execs split a stunning $1.2 billion, numbers so over the top that even those not far removed from the executive suite find their chins dropping. "I have a difficult time relating to the compensation today," says Donald E. Petersen, former chairman of Ford Motor Co., "and I've really only been out of the full-time part nine years."

But if the numbers are staggering, so too has been the performance of American business over the last decade. While tradition-bound Europe struggles to boost growth and entrepreneurialism, debt-soaked Japan remains mired in recession, and much of the developing world fights to regain its economic footing, U.S. executives are energizing older companies and creating new ones daily. The obvious questions: Are the sky-high pay and the sky-high performance linked? Has pay-for-performance worked? Is CEO greed good?

Supporters of today's compensation system say this performance is no coincidence. If paying top dollar is the price of ensuring that the boss makes moves that benefit all investors, fine. The CEOs who have responded to the challenge have created billions in value. And those who fail are pushed out far more quickly today--albeit with golden parachutes. "If shareholders are betting on a management team with their dollars and the team can move the share price, then I think it ought to participate in that achievement," says Richard A. Jalkut, CEO of telecom company Pathnet Inc. and former CEO of Nynex Inc.

In a world of cross-border mergers and global competition, those are no longer questions that only American companies have to worry about. Suddenly, the issue of whether the best way to motivate executives is to offer options-fueled pay packets is being debated around the world. Particularly in Europe, many companies are considering adding an equity component to their compensation systems--in part, to ensure that they don't lose their best talent to the U.S.. Moreover, European companies such as DaimlerChrysler and Deutsche Bank must figure out how to keep their European execs happy when they're paying a lot more to those working in their new American subsidiaries. Even in Japan, where egalitarian pay structures have long been considered a virtue, the four-year plunge in earnings has convinced Sony and others to try out options. "The level and the makeup of pay in the U.S. is beginning to have an influence on big global companies," says Vicky M. Wright, Hay Group's worldwide managing director for reward consulting.

LOOSE LINKAGE. If there's little doubt that Corporate America is doing something right by linking pay more closely to shareholder value, however, it's also clear that greed has its limits. Despite the anecdotal connection, no academic has proven that higher pay creates higher performance. While self-interest is, as Adam Smith observed centuries ago, a great motivator, the link between pay and any objective standard of performance has been all but severed in today's system. The options windfall is as likely to reward the barely passable as the truly great; moreover, it's rewarding virtually one and all in amounts that are expanding almost exponentially. "It's not that the guy steering the ship is turning the wheel the wrong way," says pay consultant Alan M. Johnson. "It's that the wheel isn't connected to the rudder."

Given the growth in sheer numbers of options being handed out, critics also warn that the seeds of future problems are already being sown. The biggest risk: In using options, companies today are in effect outsourcing the oversize compensation to the stock market. Investors willing to buy shares, after all, are paying for today's hefty raises, not the corporate coffers. But the ability to do so rests on a market that's only riding the Up escalator. Critics worry that the practice is setting untenable levels of pay expectation for the future, even as it creates hefty dilution.

The skeptics certainly have some influential company. Alan Greenspan, for one, favors indexed options--options that require that the stock does better than a market or peer group index--despite the fact that they have an accounting cost. He publicly criticized the level of CEO pay in front of the House Banking Committee in February. Or listen to Berkshire Hathaway's Warren E. Buffett, who devoted two pages of his annual report to the subject: "Although options...can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders."

Whatever the outlines of the debate, though, one thing is clear: The rich are getting richer, and fast, according to BUSINESS WEEK's 49th annual Executive Pay Scoreboard. Compiled with Standard & Poor's Compustat, a division of The McGraw-Hill Companies, the survey breaks out the pay of the highest-paid executives at 365 of the largest companies in the U.S. CEO pay again outpaced the stock market in 1998, rising 36% to the Standard & Poor's 500-stock index' 26.7%, even as earnings for the companies in the index fell 1.4%. Long-term compensation--mostly from exercised options--made up 80% of the average CEO's pay package, up from 72% in 1997. The average salary and bonus fell for the second year in a row, to $2.1 million. In some cases, that was because of poor results, but more often it was because CEOs are trimming such fixed compensation or deferring it tax-free in return for more equity.

Nice work if you can get it. That 36% raise compares to 2.7% for the average blue-collar worker, one-tenth of a percentage point above last year's boost. White-collar workers got 3.9%, according to the Bureau of Labor Statistics' Employment Cost Index. This year, the boss earned 419 times the average wage of a blue-collar worker. Although such constantly levitating numbers can be hard to truly grasp, consider this: The AFL-CIO calculates that a worker making $25,000 in 1994 would now make $138,350 this year if his pay grew at the same speed as the average CEO.

The breathtaking numbers don't even include the biggest executive payday ever. Last spring, Computer Associates Inc. paid CEO Charles B. Wang a restricted stock bonus then worth $670 million for getting its stock price above $53.33. That came on top of $7 million in salary and bonus and $22.8 million in long-term compensation the prior year. Because the payout took place in Computer Associates' 1999 fiscal year--for which the company has not yet filed a proxy--Wang's jackpot is not included in this year's pay survey. But ca has already felt the effect: In July, the company announced a $675 million charge to pay for the award to Wang and other executives, prompting a 30% stock plunge.

FAB FIVE. Still, for those convinced of the virtues of a pay-for-performance system, the top five CEOs on BUSINESS WEEK's list this year make for a pretty good argument. The companies they run--Disney, CBS, Citigroup, America Online, and Intel--are stewards of the New Economy. Most of them longtime CEOs of their companies, they have played a role in the shift of the U.S. from an industrial economy to a service economy premised on technological advancements. All five executives have, over time, revolutionized their industries and streamlined their organizations. Along the way, they have created unprecedented shareholder wealth. None of the top five would comment on their pay.

Few investors would begrudge AOL's Stephen M. Case the $159.2 million he pulled down this year. After all, he has forged one of the most successful companies in a totally new industry. And shareholders appear only too happy to ride the coattails of recently appointed CBS CEO Mel Karmazin, who earned $202 million. Most of that came from the exercise of options he had held for 10 years at Infinity Broadcasting Co., which he converted to CBS shares. Infinity was sold to CBS in 1997 and partly taken public again last year. Says a proud George H. Conrades, chairman of CBS's compensation committee: "I think his reward for the growth and the value he created is directly attributable to his leadership and probably one of the best examples of pay for performance."

Certainly, the rise in the stock market does seem to correlate with a major shift from fixed to variable pay. Although stock options have been popular in the past--primarily during bull markets--never before were they used as heavily as in the last decade. Some argue that the tighter linkage to shareholders pushed executives to make the hard choices needed to become competitive. "Can we prove that stock options did this? Of course not. Can we offer some evidence that would suggest it played a role? Yes. We really made it worth people's while to drive stock prices up, and they found ways to do it," says Jude Rich, chairman of benefits consultant Sibson & Co.

Perhaps nowhere has that been truer than in the exploding Internet sector, where the red-hot market in initial public offerings has served as an equalizer. Some upstarts now boast the same net worth as old-timers. One is Margaret C. Whitman, CEO of Web auction site eBay Inc. Granted 7 million options when she was hired in February, 1998, she made $43 million in eBay's September IPO--good enough for 17th place and the highest annual pay ever recorded by a female executive. Although most of it hasn't yet vested, Whitman's stake is now worth nearly $1 billion, thanks to the wild 1165% rise in eBay shares.

Whitman's experience exemplifies a Silicon Valley culture in which people happily toil day and night for little cash compensation in hopes of hitting the brass ring. And the creativity burst coming out of options-laden tech companies like eBay is admirable. But the staggering, near-instant jackpot is discomfiting, to say the least, to those who have worked for years to reshape businesses. If performance is really what matters, is Whitman, CEO for less than a year at a newborn company, really worth the same as ibm's Louis V. Gerstner, who has wrestled one of the country's largest companies out of near-obsolescence?

Moreover, the sheer amount of excess being created in these packages has a dark side of its own. Take two of the best-paid executives in history, Disney's Eisner and Citigroup's Sanford I. Weill. Until recently, neither has been a slouch in the performance department. In taking Disney from a moribund brand to a global multimedia entertainment outfit, Eisner has helped Disney's stock rise 450% in the past 10 years. Weill has done even more. In cobbling together financial-services businesses ranging from Travelers to Smith Barney to Citicorp in creating Citigroup, the ultimate financial supermarket, the stock has zoomed 1277% in the same period. "How many people could have done such a great job?" asks Arnold S. Ross, partner at pay consultant Hirschfeld, Stern, Moyer & Ross Inc.

But lately, things haven't been sailing along quite as smoothly. Disney's stock has trailed the market in the past two years, and earnings have fallen. While Citigroup's stock is still strong, earnings there, too, have slumped. But the weak performance hasn't taken either CEO off the Pay Express. Eisner got a new grant of 24 million shares in 1997, while Weill's compensation committee awarded him 1.7 million options in "Founder's Grants" for the Citigroup deal. That's on top of a controversial system of reload options that gives him a new grant of options every time he exercises some old ones. Moreover, both CEOs have already been handsomely paid for the stellar earlier performance. Eisner has been paid a total of $901.6 million over the last decade, and Weill, $694.8 million. Their pay levels are so high that the two scored worst and second worst, respectively, on BUSINESS WEEK's screen of executives who gave shareholders the least for their pay.

But Ray Watson, who chairs Disney's executive committee, defends the lavish 1997 package. "We wanted to tie him up for the rest of his working life. Heck, Sony would have given him half of Japan to run their company." Not letting the options vest until 2003, he argues, will keep the CEO focused on long-term growth. A Citigroup spokesman said Weill's pay "is tied to the extraordinary creation of shareholder wealth." BUSINESS WEEK's formula includes options as pay in the year they are exercised.

OPTION MANIA. Eisner and Weill may be among the princes of pay, but they're not the only CEOs whose wallets are filling faster than ever as the size of option grants rises rapidly. According to a preliminary study of 1999 proxies by Pearl Meyer & Partners Inc., the value of new stock-option grants is already up 17% over last year, even as the soaring market makes old ones more valuable. And since some 40% of large companies grant options for a fixed number of shares, according to compensation consultant Towers Perrin, the median they use as a comparison when setting their own CEOs' pay corkscrews ever higher. Cracks Nell Minow, a principal in activist investment fund LENS: "Even an English major like me can figure out that you make more money if one of the multipliers is bigger."

The increase in options is letting a lot of execs do some cashing in, even as they guard plenty of upside potential. While many have left a lot of options on the table--AOL's Case still has $286 million in options, of which about half are exercisable--many have taken a chunk home or converted some to shares, even as they ask for still larger packages. In BUSINESS WEEK's study, 53% of CEOs exercised options in 1998 worth an average $13.5 million, up from $8 million in 1997.

The pay-for-performance link is further weakened by the fact that the numbers of options are so large--and the market so high--that everyone, good or bad, has been able to take money out of the market. If you've got 10 million options of a stock granted at $80 a share, you're set to make $20 million a year if your stock goes up just $2 annually, no matter how far below the market that rise is.

Certainly, many people with underperforming shares are making such gains today. While indexes are breaking records, most money is flying either into Internet IPOs or into a small group of blue chips. The 100 largest companies in the S&P 500 have created 90% of the rise in the market so far in 1999 while many other stocks are in the tank. Yet the pay rises aren't limited to those overperformers. Case in point: Cyprus Amax Minerals CEO Milton Ward, who took home $2.1 million in salary and bonus last year, along with 425,000 options, up from 100,000 the previous year, as the stock plummeted 36%.

Another way to rescue a fortune from a swooning stock has been repricing. Rationalized as a strategy to retain executives when a company stumbles, repricings, especially when the top execs are involved, break the link between shareholders and management. Take Cendant's Henry R. Silverman, whose rapid-fire merger tactics hit a roadblock after his company, hfs Inc., merged with cuc International Inc. in 1997. Massive accounting irregularities were uncovered at cuc in the spring of 1998. Rather than let him suffer along with investors, Cendant's compensation committee signed off on the repricing of a big chunk of his 25.8 million options at $9.81, well below their original range of $17 to $31. With the stock now trading at 15, those options are worth some $54.3 million. Shareholders got no such relief. Silverman also exercised options worth $61 million to take the No. 9 slot on bw's best-paid list. He wouldn't comment, but a spokesman says he exercised most of them before the troubles surfaced.

Such options-based games only work if the market rebounds. But what if it doesn't? A look back at history (see insert) would suggest that even in a slow or bear market, executives always manage to get theirs. When the market doesn't cooperate, the rules simply change. In the 1970s, for example, a prolonged bear market made options worthless. So companies switched over to bonus plans based on the achievement of cash-based internal goals and restricted stock; although those shares can't immediately be sold, unlike options they retain their value even if they fall below their grant price.

Already, such shifts are occurring. According to Executive Compensation Advisory Services, 38% of 1999 proxies reviewed so far have restricted stock grants, up from 29% just three years earlier. Moreover, other nonoptions costs of executive pay are also going up sharply, such as pensions that must be paid until death, life insurance policies, and long-term incentive plans tied to other performance measures, such as sales and earnings growth. Assorted perquisites such as the $144,415 payment to Charles M. Cawley, CEO of mbna Bank, for "personal assistants," are also on the rise. The effect of piling on all these goodies, warns Harvard Business School professor Samuel L. Hayes: "It's not a level playing field on the downside."

Another growing liability is the cost of both bringing in a new CEO--and booting the old one. Even if a company moves against an underperforming CEO, it must pay him as much to go as it would have had he been a success. Electronic Data Systems Corp. took a $35 million hit to earnings to fund departing CEO Lester M. Alberthal Jr.'s severance package, even as it brought in new CEO Richard H. Brown with such features as a $4.5 million signing bonus, 1 million options, and 275,000 shares of restricted stock. He too received an ironclad agreement to take home a good chunk of that should it not work out. Often, not even taxes count: 52% of companies have agreed to pay any taxes coming from "excessive" parachute payments last year, according to Executive Compensation Advisory Services.

Add a bear market to these goodies, and many companies may be in big trouble. While the nonoptions costs of pay are already rising, there is no way companies will be able to match today's windfall option gains for CEOs. Yet it's unlikely that CEOs will tolerate a 95% pay cut because the market finally stalls. "When someone that made $50 million is making $5 million to $10 million, they're going to think they're just as good a manager as they were a year ago," says Alfred Rappaport, management professor at Northwestern's Kellogg School.

Dilution is another lien on the future that the love affair with options has ignored. While many companies have pushed options down the ranks while simultaneously showering the boss, the potential dilution has increased rapidly. According to pay consultant Watson Wyatt Worldwide, the average overhang--which is options already granted plus options available for grant, divided by the number of outstanding shares--hit 13% in 1997, up from 5% in 1988. Many institutional investors now vote against any plan where the potential dilution is over 10%. According to Strategic Compensation Research Associates, the votes against new stock plans is inching up, reaching an average 14.8% for the second half of 1998.

Although companies argue that they need the shares to motivate employees, a new study suggests there's a limit. Watson Wyatt's Ira T. Kay found that the one-third of companies with the highest overhang had lower shareholder return than companies with medium and low overhang. He found a sweet spot at around 10%--a level that many companies are now surpassing. A few have decided options aren't worth it. When Warren Buffett bought General Re Corp. last year, he replaced the option plan with a cash-based incentive program and took a $36 million charge. In doing acquisitions, Buffett always gets rid of options and takes a hit to earnings. Sometimes the cost is so high it kills the deal.

Stock buybacks have become a common way for companies to counter dilution, but that's hardly trouble-free. Despite the soaring market, stock buybacks are at an all-time high; net share issuance was -$391.4 billion in the second half of 1998, down from -$134.2 billion for the first half of 1998. While many companies don't say why they do buybacks, some, such as Microsoft Corp., have specifically said they are doing so to reduce dilution. Usually, buybacks are done to boost the stock price in a down market, but this time, companies are buying back their stock at record prices. John M. Youngdahl, senior money market economist at Goldman, Sachs & Co., notes that debt levels are increasing at the same time. The combination may soon put pressure on capital spending. "In past episodes of lofty share valuations, you would see the more traditional financial response when profit growth slowed--the issuing of shares," he says. "This time we've seen high valuations and a slowdown in profit growth and yet share issuance has gone sharply negative." Something, he says, may have to give.

A final bit of rain on the pay parade is the prospect of shareholder and employee outrage if the music stops. Complaints have been fairly muted this year, because many people have shared in some of the market-linked prosperity. But should the market backslide--especially in a year when many labor unions are scheduled for wage negotiations--the CEO-worker ratios may get a lot more scrutiny. "You will see a lot more screaming as soon as the market turns down a little bit," warns Richard L. Trumka, secretary-treasurer of the AFL-CIO. For now, that day remains a ways off. In today's market, the only true conclusion is that if greed is good, it's best for the CEO.

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