Getting a Handle on CEO Severance Pay

Many executives receive lavish compensation after a mediocre term of service. But boards are gaining the independence to ask tough questions

Boards of directors are making progress in coming to grips with linking the pay of CEOs to their actual performance, but severance pay for CEOs (BusinessWeek, 7/3/08) remains a major issue, says David Swinford, president and CEO of Pearl Meyer & Partners, a New York executive compensation consultancy. And the next Administration, whether a Republican or Democrat is in the White House, will adopt "say on pay" legislation, adds Swinford, whose firm is no longer associated with the well-known consultant Pearl Meyer (, 10/16/07). Here are edited excerpts from a recent conversation:

Now that there are more independent directors on boards and on their compensation committees, how is that affecting CEO pay decisions?

Once you get independent people on the board, you've got people who can ask questions to understand more thoroughly what's being proposed to them. They tend to be a little more rigorous in their assessment of performance. When things are going well, management gets paid out, but when things don't go well, there has been a temptation to look for why management was doing their very best and find a reason to give them more money. That used to be extremely common. But it's much less common now. The crux of getting a grip on pay is to ensure that the risk side of the pay equation is in force. If performance falls short, pay falls short. That's a significant change from the past.

Are compensation committees getting tougher?

The meetings are more rigorous. If there is someone on the board who is a critic of executive pay, you should get him on the compensation committee. Such people sometimes make the compensation committee meetings tougher. But the fact is, they're going to weigh in eventually, and it's good discipline to answer the critics during the committee process.

It's also very clear that compensation committees want a strong tie with the audit or financial policy committee. The compensation committee is now much more concerned than in the past about how the money is counted. How is performance measured? Are the goals set high enough? So there is more financial discipline on compensation committees these days. There is a much stronger tendency to get behind the performance and understand the quality of the performance. It's not just "What were the results?" They're also asking: "Did we meet our cash-flow goal because we cut back on capital spending? Did we defer maintenance? Did we do anything crazy with accounting to get advance revenue or postpone expenses?"

What is the evidence that boards are doing a better job of linking CEO pay with performance?

It's anecdotal. There are fewer public screw-ups than there used to be. We can look at a number of examples every year where pay does not reflect performance, but there are fewer than there used to be. …What we look for is fewer instances where somebody is being paid an outrageous amount of money to go away or somebody is making a lot of money and getting incentive plan payouts at a time when the company is not performing well.

On a net basis, CEO pay is still going up?

Sure, over a period of years, sure. But I expect pay this year is probably going to be down because the market is down and economic performance isn't as good. That's not going to be across the board because some industries are doing fine.

Are boards still playing the game of trying to peg their CEO pay to the 75th percentile of their so-called comparable companies?

It's become much more commonplace to say: "Let's target the median. We want to be in the middle of the pack and we will design our incentive plans so that our payouts put us higher in the hierarchy of pay when our performance is better, but we don't pay as much when performance is bad." When performance is superior, pay will be superior. When performance is inferior, pay will be inferior.

What has changed in the debate about whether compensation consultants such as yourself have a conflict of interest in working for both management and the board (, 12/17/07)?

Consultant independence is a major conceptual issue. There are certainly a number of companies that have decided that the consultants can only work for the compensation committee. I will tell you from personal experience that, among those firms that provide other services to companies, I've never seen a problem in terms of the objectivity of pay recommendations. It's not a structural issue. I think it's a matter of the individual. Some consultants have the intestinal fortitude to stand up for what they think and tell the committee and management what they believe and stick to it. Other people waffle under pressure.

Why are so many failed CEOs walking way with huge severance payments?

The first problem is if you hire a CEO from the outside who is leaving compensation on the other company's table. If you're smart, as a hiring company, you don't cash them out of that. You transfer the obligation to your company. …The problem with that is that almost always, you're going to have to guarantee to pay it out if you terminate them for other than cause. That is what you saw with Bob Nardelli at Home Depot (HD).

If a CEO comes in from the outside, there ought to be declining protection. Suppose it says in the contract that if they are terminated without cause within three years, you're going to give them [three years of pay], you should have that decline. So after a year working for you, they only get two years of severance. After two years of working for you, they only get one year of severance. If it doesn't work out right away, yes, they are protected. But after that, they start to get something that looks more like a typical compensation program.

Will legislation to give shareholders a nonbinding "say on pay," meaning a vote on CEO compensation, happen?

It's so easy for the next Administration to do it. At a minimum, you have a Democratic Congress. Even if John McCain were elected President, he would sign it.

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