The CEOs' Gravy Train May Be Drying Up
Two years ago, Boise Cascade Corp.'s (BCC ) CEO, George J. Harad, received a large grant of stock options with no strings attached. A rising market, regardless of his performance, would make them worth a tidy sum. But last April, Boise investors staged a small revolt, with 12% backing a resolution to do away with traditional stock options. A few months later, they got the next best thing. Instead of options, the board decided that the bulk of Harad's $9 million 2003 pay package would be paid in restricted stock that vests in 2006. But if he misses his cash-flow targets, he could lose it all. Says Harad: "I have the opportunity to make a lot of money, but only if the company meets the goals."
Across Corporate America, boards are getting the message. While big pay packages will continue as long as executives exercise options awarded years ago, they will almost certainly fall in coming years. A mix of forces -- from accounting changes to enraged investors -- has prompted many compensation committees to make changes likely to keep future increases well below the double-digit gains of the 1990s. Among the reforms: a closer link between pay and performance. "This isn't a transition," says Pearl Meyer, a New York pay adviser. "This is a transformation."
In 2003, CEOs got a taste of the future. Initial results indicate that the overall rise in executive compensation -- the first such jump in three years -- was modest. Among 252 of the largest U.S. companies in the Standard & Poor's (MHP ) ExecuComp database that have filed proxies so far, average CEO pay was up 5.2% in 2003, to $7.8 million. That tally includes salary, bonus, and stock as well as gains from the exercise of options awarded in earlier years. The key reasons for the increase: Boards awarded bigger bonuses amid a surge in profits and rising stocks allowed many CEOs to cash in once-worthless options. Moreover, more boards are paying CEOs with stock grants, which BusinessWeek counts toward compensation, rather than in stock options, which it does not.
Of course, there will always be gravity-defying pay packages. The highest-paid exec so far for 2003 was not even a CEO. Nigel W. Morris, vice-chairman of Capital One Financial Corp. (COF ), cashed in options for a haul of $147.3 million. Among CEOs at companies that have filed their proxies so far, Steven P. Jobs of Apple Computer Inc. (AAPL ) comes out on top. Although he can't collect until 2006, Jobs swapped 2.7 million underwater options for a restricted stock grant worth $74.8 million.
In the future, though, such sky-high pay may become the exception. CEOs are no longer being handed huge fistfuls of options, and their current stockpiles are dwindling. At companies such as Alcoa (AA ), Verizon Communications (VZ ), and Sun Microsystems (SUNW ), CEOs saw option grants reduced or replaced by stock. Mandatory option expensing, expected to start in 2005, will keep pressure on boards to reduce grants. "We're going to see more reductions in CEO pay," says PepsiCo Inc. (PEP ) CEO Steven S. Reinemund, who's girding for his own cut in 2004. "Expensing options has caused everyone to focus on it."
The governance reforms of the past three years have also provided a big push. At General Electric Co. (GE ) and at IBM (IBM ), which both added independent directors in recent years, boards have performed radical surgery to better tie pay to performance. GE's Jeffrey R. Immelt could lose all 250,000 shares of stock GE awarded him last year unless he meets performance goals. And IBM's Samuel J. Palmisano will get options, but they'll be worthless until the stock rises by 10%. "Shareholders have been uncomfortable with [traditional] options," says J. Randall MacDonald, IBM's senior vice-president for human resources. "We listened."
But it's not just boards with fresh blood that are making changes. At Procter & Gamble Co. (PG ), CEO Alan G. Lafley must now own six times his base salary in P&G stock and hold shares he acquires through option exercises for a year. At Alcoa Inc., the board is reducing option terms from 10 years to 6 and phasing out a "reload" feature that replaces exercised options -- potentially reducing CEO Alain J.P. Belda's future pay.
SOME HOLDOUTS. One reason directors might be getting tougher: They're afraid of losing their jobs. A Securities & Exchange Commission plan would allow big investors to nominate directors in 2005 if this year 35% of shareholders withhold support for a nominee. Proxy advisers Institutional Shareholder Services and Glass Lewis & Co., Big Labor, and mutual funds are all gunning for such directors.
Of course, while most boards are revamping pay, some seem impervious to reform. At SBC Communications Inc. (SBC ), 2003 operating income was down 25% and the stock lagged its peers. Yet CEO Edward E. Whitacre Jr. earned $19.6 million, including a $5.7 million bonus and a $7.2 million stock grant -- a 93% increase over 2002. The company notes that net profit jumped 50%, but that was due largely to accounting changes. A spokesman also adds that the increase was justified because Whitacre met all the board's goals, including targets for free cash flow and customer satisfaction.
At Apple, Jobs's $74.8 million options-for-stock swap last March came after a three-year stretch in which the stock plummeted 80%, and then barely moved. What's more, Jobs will receive them in 2006, regardless of performance. But Apple notes he earns just $1 a year in salary and argues that only a third of the three-year grant should be counted in any given year. Moreover, compensation committee chairman William V. Campbell says the stock was intended to keep Jobs, who saved Apple in the late '90s and devised its digital music business, at the helm. Says Campbell: "We did what we thought was a good and fair practice."
There will always be exceptions, but most boards are making changes that will result in fewer riches for CEOs. Is $7.8 million exorbitant? Probably, but investors can take comfort in the fact that it's unlikely to get much worse.
By Louis Lavelle in New York, with Diane Brady in New York and bureau reports
— With assistance by Diane Brady