answer the question after the reading

YES +d Ira T. Kay Don't Mess with CEOPay

For years, headlines have seized on dramatic accounts of outrageous amounts earned by executives-often of failing companies-and the financial tragedy that can befall both shareholders and employees when CEOsline their own pockets at the organization's expense. Images of lavish executive life- styles are now engraved in the popular consciousness. The result: public sup- port for political responses that include new regulatory measures and a long list of demands for greater shareholder or government control over executive compensation.

These images now overshadow the reality of thousands of successful com- panies with appropriately paid executives and conscientious boards. Instead, fresh accusations of CEOs collecting huge amounts of undeserved pay appear daily, fueling a full-blown mythology of a corporate America ruled by execu- tive greed, fraud, and corruption.

This mythology consists of two related components: the myth of the failed pay-for-performance model and the myth of managerial power. The first myth hinges on the idea that the link between executive pay and corporate performance-if it ever existed-is irretrievably broken. The second myth accepts the idea of a failed pay-for-performance model and puts in its service the image of unchecked CEOs dominating subservient boards as the explanation for decisions resulting in excessive executive pay. The powerful combination of these two myths has captured newspaper headlines and shareholder agen- das, regulatory attention and the public imagination.

This mythology has spilled over into the pages of Across the Board, where the September/October cover story links high levels of CEO pay to the country's growing income inequality and wonders why U.S. workers have not taken to the streets to protest "the blatant abuse of privilege" exercised by CEOs. In "The (Revolution That Never Was," James Krohe Jr. manages to reference Marie Antoinette, Robespierre, Adam Smith, Alexis de Tocqueville, Andrew Jackson, Kim Iong II, Jack Welch, guerrilla warfare, "economic apart- heid," and police brutality in Selma, Ala., in an article that feeds virtually every conceivable element of the myth of executive pay and wonders why we have not yet witnessed calls for a revolution to quash the "financial frolics of today's corporate aristocrats."

In a very different Across the Board feature story published a few months earlier, the myth of managerial power finds support in an interview with one of

From Across the Board, january/February 2006. Copyright © 2006 by Conference Board, Inc. Reprinted by permission.

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the myth's creators, Harvard professor Lucian Bebchuk, who believes that the pay-for-performance model is broken and that executive control over boards is to blame. Bebchuk is a distinguished scholar who has significant insights into the executive-pay process, but he greatly overestimates the influence of managerial power in the boardroom and ignores empirical evidence that most companies still operate under an intact and explicit pay-for-performance model. And although he acknowledges in his interview with ATB editor A.J. Vogl that" American com- panies have been successful and executives deserve a great deal of credit," his arguments about managerial power run counter to the realities of this success.

Fueling the Fiction These two articles, in different ways, contribute to what is now a dominant image of executives collecting unearned compensation and growing rich at the expense of shareholders, employees and the broader community. In recent years, dozens of reporters from business magazines and the major newspapers have called me and specifically asked for examples of companies in which CEOs received exorbitant compensation, approved by the board, while the company performed poorly. Not once have I been asked to comment on the vast major- ity of companies-those in which executives are appropriately rewarded for performance or in which boards have reduced compensation or even fired the CEO for poor performance.

I have spent hundreds of hours answering reporters' questions, providing extensive data and explaining the pay-for-performance model of executive com- pensation, but my efforts have had little impact: The resulting stories feature the same anecdotal reporting on those corporations for which the process has gone awry. The press accounts ignore solid research that shows that annual pay for most executives moves up and down significantly with the company's perfor- mance, both financial and stock-related. Corporate wrongdoings and outland- ish executive pay packages make for lively headlines, but the reliance on purely anecdotal reporting and the highly prejudicial language adopted are a huge dis- service to the companies, their executives and employees, investors, and the public. The likelihood of real economic damage to the U.S. economy grows daily.

For example, the mythology drives institutional investors and trade unions with the power to exert enormous pressure on regulators and executive and board practices. The California Public Employees' Retirement System-the nation's largest public pension fund-offers a typical example in its Nov. IS, 2004, announcement of a new campaign to rein in "abusive compensation practices in corporate America and hold directors and compensation commit- tees more accountable for their actions."

The AFL-CIO's website offers another example of the claim that man- agerial power has destroyed the efficacy of the pay-for-performance model: "Each year, shocking new examples of CEO pay greed are made public. Inves- tors are concerned not just about the growing size of executive compensation packages, but the fact that CEO pay levels show little apparent relationship to corporate profits, stock prices or executive performance. How do CEOs do it? For years, executives have relied on their shareholders to be passive absentee

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owners. CEOs have rigged their own compensation packages by packing their boards with conflicted or negligent directors."

The ROI of the CEO As with all modern myths, there's a grain of truth in all the assumptions and newspaper stories. The myths of managerial power and of the failed pay-for- performance model find touchstones in real examples of companies where CEOs have collected huge sums in cash compensation and stock options while shareholder returns declined. (You know the names-there's no need to mention them again here.) Cases of overstated profits or even outright fraud have fueled the idea that executives regularly manipulate the measures of performance to justify higher pay while boards default on their oversight responsibilities. The ability of executives to time the exercise of their stock options and collect additional pay through covert means has worsened percep- tions of the situation both within and outside of the world of business.

These exceptions in executive pay practices, however, are now commonly mistaken for the rule. And as Krohe's article demonstrates, highly paid CEOs have become the new whipping boys for social critics concerned about the general rise in income inequality and other broad socioeconomic problems. Never mind that these same CEOs stand at the center of a corporate model that has generated millions of jobs and trillions of dollars in shareholder earn- ings. Worse, using CEOs as scapegoats distracts from the real causes of and possible solutions for inequality.

The primary determinant of CEO pay is the same force that sets pay for all Americans: relatively free-if somewhat imperfect-labor markets, in which companies offer the levels of compensation necessary to attract and retain the employees who generate value for shareholders. Part of that pay for most execu- tives consists of stock-based incentives. A 2003 study by Brian J. Hall and Kevin J. Murphy shows that the ratio of total CEO compensation to production work- ers' average earnings closely follows the Dow Jones Industrial Average. When the Dow soars, the gap between executive and non-executive compensation widens. The problem, it seems, is not that CEOs receive too much performance- driven, stock-based compensation, but that non-executives receive too little.

The key question is not the actual dollar amount paid to a CEO in total compensation or whether that amount represents a high multiple of pay of the average worker's salary but, rather, whether that CEO creates an adequate return on the company's investment in executive compensation. In virtually every area of business, directors routinely evaluate and adjust the amounts that companies invest in all inputs, and shareholders directly or indirectly endorse or challenge those decisions. Executive pay is no different.

Hard Realities The corporate scandals of recent years laid bare the inner workings of a hand- ful of public companies where, inarguably, the process for setting executive pay violated not only the principle of pay-for-performance but the extensive

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set of laws and regulations governing executive pay practices and the role of the board. But while I condemn illegal actions and criticize boards that reward executives who fail to produce positive financial results, I know that the vast majority of U.S. corporations do much better by their shareholders and the public. I have worked directly with more than a thousand publicly traded companies in the United States and attended thousands of compensation- committee meetings, and I have never witnessed board members straining to find a way to pay an executive more than he is worth.

In addition, at Watson Wyatt I work with a team of experts that has conducted extensive research at fifteen hundred of America's largest corpora- tions and tracked the relationship between. these pay practices and corporate performance over almost twenty years. In evaluating thousands of companies annually, yielding nearly twenty thousand" company years" of data, and pool- ing cross-sectional company data over multiple years, we have discovered that for both most companies and the "typical" company, there is substantial pay- for-performance sensitivity. That is, high performance generates high pay for executives and low performance generates low pay. Numerous empirical aca- demic studies support our conclusions.

Our empirical evidence and evidence from other studies have produced the following key findings:

1. Executive pay is unquestionably high relative to low-level corporate positions, and it has risen dramatically over the past ten to fifteen years, faster than inflation and faster than average employee pay. But executive compensation generally tracks total returns to shareholders-even including the recent rise in pay.

2. Executive stock ownership has risen dramatically over the past ten to fifteen years. High levels of CEO stock ownership are correlated with and most likely the cause of companies' high financial and stock- market performance.

3. Executives are paid commensurate with the skills and talents that they bring to the organization. Underperforming executives routinely receive pay reductions or are terminated-far more often than press accounts imply.

4. CEOs who are recruited from outside a company and have little influence over its board receive compensation that is competitive with and often higher than the pay levels of CEOs who are promoted from within the company.

S. At the vast majority of companies, even extraordinarily high levels of CEO compensation represent a tiny fraction of the total value cre- ated by the corporation under that CEO's leadership. (Watson Wyatt has found that U.S. executives receive approximately 1 percent of the net income generated by the corporations they manage.) Well-run companies, it bears pointing out, produce significant shareholder returns and job security for millions of workers.

Extensive research demonstrates a high and positive correlation between executive pay and corporate performance. For example, high levels of execu- tive stock ownership in 2000, created primarily through stock-option awards,

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correlated with higher stock-market valuation and long-term earnings per share over the subsequent five-year period. In general, high-performing com- panies are led by highly paid executives-with pay-for-performance in full effect. Executives at low-performing companies receive lower amounts of pay. Reams of data from other studies confirm these correlations.

Why CEOs Are Worth the Money The huge gap between the realities of executive pay and the now-dominant mythology surrounding it has become even more evident in recent years. Empirical studies show that executive compensation has closely tracked cor- porate performance: Pay rose during the boom years of the 1990s, when U.S. corporations generated huge returns, declined during the 2001-03 profit slow- down, and increased in 2004 as profits improved. The myth of excessive execu- tive pay continued to gain power, however, even as concrete, well-documented financial realities defied it.

The blind outrage over executive pay climbed even during the slow- down, as compensation dropped drastically. During this same period, in the aftermath of the corporate scandals, Congress and the U.S. regulatory agencies instituted far-reaching reforms in corporate governance and board composi- tion, and companies spent millions to improve their governance and trans- parency. But the critics of executive pay and managerial power were only encouraged to raise their voices.

It might surprise those critics to learn that CEOs are not interchangeable and not chosen by lot; they are an extremely important asset to their com- panies and generally represent an excellent investment. The relative scarcity of CEO talent is manifested in many ways, includingthe frenetic behavior of boards charged with filling the top position when a CEO retires or departs. CEOs have Significant, legitimate, market-driven bargaining power, and in pay negotiations, they use that power to obtain pay commensurate with their skills. Boards, as they should, use their own bargaining power to retain talent and maximize returns to company shareholders.

Boards understand the imperative of finding an excellent CEO and are willing to risk millions of dollars to secure the right talent. Their behavior is not only understandable but necessary to secure the company's future success. Any influence that CEOs might have over their directors is modest in compari- son to the financial risk that CEOs assume when they leave other prospects and take on the extraordinarily difficult task of managing a major corporation, with a substantial portion of their short- and long-term compensation contin- gent on the organization's financial success.

Lucian Bebchuk and other critics underestimate the financial risk entailed in executive positions when they cite executives' large severance packages, derided as "golden parachutes." Top executive talent expects and can com- mand financial protections commensurate with the level of risk they assume. Like any other element of compensation, boards should and generally do eval- uate severance agreements as part of the package they create to attract and retain talent. In recent years, boards have become more aware of the damage

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done when executive benefits and perquisites are excessive and not aligned with non-executive programs, and are now reining in these elements.

Properly designed pay opportunities drive superior corporate perfor- mance and secure it for the future. And most importantly, many economists argue, the U.S. model of executive compensation is a significant source of com- petitive advantage for the nation's economy, driving higher productivity, prof- its, and stock prices.

Resetting the Debate Companies design executive pay programs to accomplish the classic goals of any human-capital program. First, they must attract, retain, and motivate their human capital to perform at the highest levels. The motivational factor is the most important, because it addresses the question of how a company achieves the greatest return on its human-capital investment and rewards executives for making the right decisions to drive shareholder value. Incentive-pay and pay- at-risk programs are particularly effective, especially at the top of the house, in achieving this motivation goal.

Clearly, there are exceptions to the motivational element-base salaries, pensions, and other benefits, for example-that are more closely tied to reten- tion goals and are an essential part of creating a balanced portfolio for the employee. The portfolio as a whole must address the need for income and security and the opportunity for creating significant asset appreciation.

A long list of pressures, including institutional-investor push back, accounting changes, SEC investigations, and scrutiny from labor unions and the media, are forcing companies to rethink their executive-compensation programs, especially their stock-based incentives. The key now is to address the real problems in executive compensation without sacrificing the perform- ance-based model and the huge returns that it has generated. Boards are strug- gling to achieve greater transparency and more rigorous execution of their pay practices-a positive move for all parties involved.

The real threat to U.s. economic growth, job creation, and higher liv- ing standards now comes from regulatory overreach as proponents of the mythology reject market forces and continue to push for government and institutional control over executive pay. To the extent that the mythology now surrounding executive pay leads to a rejection of the pay-for-performance model and restrictions on the risk-and-reward structure for setting executive compensation, American corporate performance will suffer.

There will be more pressure on boards to effectively reduce executive pay. This may meet the social desires of some constituents, but it will almost surely cause economic decline, for companies and the U.S. economy. We will see higher executive turnover and less talent in the executive suite as the most qualified job candidates move into other professions, as we saw in the 1970s, when top candidates moved into investment banking, venture-capital firms, and consulting, and corporate performance suffered as a result.

Our research demonstrates that aligning pay plans, incentive opportuni- ties, and performance measures throughout an organization is key to financial

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success. Alignment means that executives and non-executives alike have the opportunity to increase their pay through performance-based incentives. As new regulations make it more difficult to execute the stock-based elements of the pay-for-performance model, for example, by reducing broad-based stock options, we will see even less alignment between executives' compensation and the pay packages of the rank-and-file. We are already witnessing the unin- tended consequences of the new requirement for stock-option expensing as companies cut the broad-based stock-option plans that have benefited mil- lions of workers and given them a direct stake in the financial success of the companies for which they work.

Instead of changing executive pay plans to make them more like pay plans for employees, we should be reshaping employee pay to infuse it with the same incentives that drive performance in the company's upper ranks. A top-down regulatory approach to alignment will only damage the entire market-based, performance-management process that has worked so well for most companies and the economy as a whole. Instead of placing artificial limits on executive pay, we should focus squarely on increasing performance incentives and stock ownership for both executive and non-executive employ- ees and rewarding high performers throughout the organization, from top to bottom. Within the context of a free-market economy, equal opportunity- not income equality by fiat-is the goal.

The short answer to James Krohe's question of why high levels of executive pay have not sparked a worker revolution is that the fundamental model works too well. Workers vote to support that model every day when they show up for work, perform well, and rely on corporate leadership to pursue a viable plan for meeting payroll and funding employee benefits. Shareholders vote to support the model every time they purchase shares or defeat one of the dozens of pro- posals submitted in recent years to curb executive compensation. Rejecting the pay-for-performance model for executive compensation means returning to the world of the CEO as caretaker. And caretakers-as shown by both evidence and common sense-do not create high value for shareholders or jobs for employees.

In some ways, the decidedly negative attention focused on executive pay has increased the pressure that executives, board members, HR staffs, and com- pensation consultants all feel when they enter into discussions about the most effective methods for tying pay to performance and ensuring the company's success. The managerial-power argument has contributed to meaningful dis- cussions about corporate governance and raised the level of dialogue in board- rooms. These are positive developments.

When the argument is blown into mythological proportions, however, it skews thinking about the realities of corporate behavior and leads to funda- mental misunderstandings about executives, their pay levels, and their role in building successful companies and a flourishing economy. Consequently, the mythology now surrounding executive compensation leads many to reject a pay model that works well and is critical to ongoing growth at both the corpo- rate and the national economic level. We need to address excesses in executive pay without abandoning the core model, and to return the debate to a rational, informed discussion. And we can safely leave Marie Antoinette out of it.

Edgar Woolard, Jr. NO CEOsAre Being Paid Too Much

There's a major concern out there for all of us. I personally am extremely saddened by the loss of the respect that this country's corporate leaders have experienced. We've had a double blow in the last ten years or so. The first one we know way too much about-the fraud at Enron, Tyco, Adelphia, World- Com, and many others.

The CEOs say there were a few rotten apples in that barrel, and maybe that's the answer-but there are a hell of lot more rotten apples than I would have ever guessed. But that's just the base of one of the issues that has eroded the trust and confidence in American business leaders.

The second one is the perception of excess compensation received by CEOs getting worse year by year. And if directors agree, they can be the lead- ers in making a very important change. I'd like to deal with it by describing several myths about compensation and trying to undermine them.

Myth #1: CEO Pay by Competition The first is the myth that CEO pay is driven by competition-and to that I say "bull." CEO pay is driven today primarily by outside consultant surveys, and by the fact that many board members have bought into the concept that your CEO has to be at least in the top half, and maybe in the top quartile. So we have the "ratchet, ratchet, ratchet" concept. We all understand it well enough to know that if everybody is trying to be in the top half, everybody is going to get a hefty increase every year. If Bill and Sally get an increase in their total compensation, I have to get an increase so that I will stay in the top half.

How can we change that? In 1990, we addressed this issue at DuPont. I became CEO in 1989, and

I was concerned about what was evident even then. A 1989 Business Week article talked about executive pay-who makes the most and are they worth it: Michael Eisner, $40 million in 1988; RossJohnson, $20 million; and others. I don't know Eisner, but I know that even fifteen years later he's one of the most criticized CEOs in the country.

What we did at DuPont was go to a simple concept: internal pay equity. I went to the board and the compensation committee and said, "We're going to look at the people who run the businesses, who make decisions on prices and new products with guidance from the CEO-the executive vice presidents- and we're going to set the limit of what a CEO in this company can be paid at 1.5 times the pay rate for the executive vice president-SO percent."

From Across the Board, January/February 2006. Copyright © 2006 by Conference Board, Inc. Reprinted by permission.

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That to me seemed equitable. It had been anywhere from 30 to SO percent in the past. I said, "Let's set it at SO percent, and we're not going to chase the sur- veys." And this is the way DuPont has done it ever since. I think we have tweaked it up a little bit since then, but using a multiple still is the right way to go.

Board members can do this by suggesting that the HR and compensation people look at what's happened to internal pay equity, and seriously consider going in that direction. That will solve this problem in a great way.

Myth #2: Compensation Committees Are Independent I give a "double bull" to this one. It could be that committees are becoming more independent, but over the last fifteen years they certainly haven't been.

Let me describe how it works: The compensation committee talks to an outside consultant who has surveys that you could drive a truck through and that support paying anything you want to pay. The consultant talks to the HR vice president, who talks to the CEO. The CEO says what he'd like to receive- enough so he will be "respected by his peers." It gets to the HR person, who tells the consultant, and the CEO gets what he's implied he deserves. The members of the compensation committee are happy that they're independent, the HR per- son is happy, the CEO is happy, and the consultant gets invited back next year.

There are two ways to change that as well. Here's the first one. When John Reed came back to the New York Stock Exchange to try to clean up the mess after Dick Grasso, he made the decision-which I admire him for-that the board was going to have its own outside consultant, one who was not going to be allowed to talk to internal people-not to the HR vice president, not to the CEO.

I'm the head of the comp committee at the NYSE, and when I talk with our outside consultant, he gives us his ideas of what he thinks the pay package ought to be. Then, with the consultant there, I talk to the compensation com- mittee, and we make a decision. I talk to the HR vice president to see if he has any other thoughts, but the committee is totally independent.

The other way to change things is to truly insist on pay-for-performance, which everyone likes to talk about but no one does. Boards pay everybody in the top quartile whether they have good performance or bad performance-or even if they're about to be fired.

Well, I was on a board fifteen years ago, and four CEOs were on the com- pensation committee, and for two consecutive years, we gave the CEO and the executives there no bonus, no salary increase, and modest stock options, because their performance was lousy those years. After that, they did extremely well, and we paid them extremely well. That's how pay-for-performance should work.

Myth #3: Look How Much Wealth I Created This one is really a joke. It was born in the 1980s and '90s during the stock- market bubble, when all CEOs were beating their chest about how much wealth they were creating for shareholders. And I'd look to the king, Jack Welch. Jack's

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the best CEO of the last fifty years, and I've told him this. But he likes to say, "I created $400 billion worth of wealth." No, Jack-no, you didn't. He said that when GE's stock was at 60, but when the bubble burst it went to 30, and it's in the low 30s now. So he created $150 to $200 billion.

But besides the actual figure, there are two things wrong with his claim. Now, I don't care how much money Jack Welch made. God bless him; I think he's terrific. But what did it do? It set a new level for CEO pay based on the stock-market bubble; all the other CEOs were saying, "Look how much wealth I created."

So you've got this more recent high level of executive pay, and then you've got the ratcheting effect in the system. Those things have to change.

Myth #4: Severance for Failing The last one is the worst of all. Any directors who agree to give these huge severance pay packages to CEOswho fail-Philip Purcell of Morgan Stanley got $114 million, Carly Fiorina of Hewlett-Packard got $20 million-why are you doing that? No one else gets paid excessively when they fail. They get fired; they get fair severance.

All of this is killing the image of CEOs and corporate executives. When it comes to our image, we're in the league with lawyers and politicians. I don't want to be there, and I don't think you do either. We need the respect of our employees and the general public. And there's a lot of skepticism about lead- ers in politics and in churches and in the military-but we can't have it in the business community, because we're the backbone of the market system that has made this country great and created so many opportunities for people. We can't be seen as either dishonest or greedy.

What can you do about it? Some of you CEOs need to show leadership and say, "We're going to do

internal pay equity." It's easy to get the data, and then you can decide what you think is fair and how much you think the CEO contributes versus the other business leaders who make their companies so strong.

Compensation committees need to seriously consider implementing internal pay equity. Pay only for outstanding performance. Quit giving people money just because Bill and Sally are getting it. Consider going to an inde- pendent consultant that deals only with the board while you deal with HR and the CEO.

Last, take a look at stock-option packages. Not just for one year but the mega-grants that built up in the 1980s and '90s. If you've given huge stock- option packages for the last five years, look at their value. There's nothing in the Bible that says that you have to give increased stock options every year. Give a smaller grant; give a different kind of grant; put some kind of limits on.

There are many ways to do it, but it's important to get the system back under control. It's important for our image, for our reputation, for integrity, for trust, and for our leadership in this country.

Is CEOCompensation Justified by Performance?

POSTSCRIPT

In 1992, when Geoffrey Colvin wrote the article bringing the problem of CEO compensation to public attention, he was worried about the country's perception of annual outlays of $1.7 million average total CEO compensation for almost 300 large companies, with pay going up to a whopping $3.2 million annually for the really big companies. By 1995, the CEO of a multibillion-dollar company received an average of $4.37 million in compensation, up 23 percent from 1994. And it got worse from there, with 1996 figures going through the roof: how on earth could Jack Welch, CEO of General Electric, spend the $21.4 million in salary and performance bonuses (and about $18 million in stock options) that he received in 1996, or Green Tree Financial Corporation's Law- rence Coss spend his $102.4 million in salary and bonus (plus stock options worth at least $38 million)? The Business Section of The New York Times at the end of 1997 glowed with projected bonuses of $11 billion for Wall Street that year-that was over and above salary, and before stock options. Two years later, Jack Welch was pulling in $68 million. As per the introduction to this issue, the amounts then tripled, quadrupled, into amounts per individual that dwarf the annual health budgets of most of the world. The situation is not correcting itself.

The political impact of these salaries is muted for the present, probably due to the failure of the American left, or liberal political orientation, to find a powerful spokesperson who might gain the confidence of the American people. The moral dimensions of the problem have not changed since the days of the prophet Amos of the Hebrew Scriptures: What right have the rich to enjoy their warm palaces and mansions, dining plentifully on the best food from all the world, while the poor suffer from hunger and cold? But the political dimensions are volatile, and dependent upon the rest of the system to provide context and opportunity. This issue will be with us for a while.

Suggested Readings Lucian Bebchuk and Jesse Fried, Pay Without Performance: The Unfulfilled

Promise of Executive Compensation (Cambridge: Harvard University Press, 2006).

Rocco Huang, "Because I'm Worth It? CEO Pay and Corporate Governance," Business Review (Federal Reserve Bank of Philadelphia) (2010),pp. 12-19.

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Ira Kayand Steven Van Putten, Myths and Realities of Executive Pay (Cambridge: Cambridge University Press, 2007).

Jean MacGuire, et al., "CEO Incentives and Corporate Social Performance," Journal of Business Ethics (vol. 45, no. 4, July 2003).

Ben Steverman, "CEOs and the Pay-far-Performance Puzzle," BusinessWeek Online (p. 2, 2009).

Ronald A. Wirtz, "Goldilocks in the Corner Office," The Region (The Federal Reserve Bank of Minneapolis) (vol. 20, no. 4, 2006), pp. 22-35.

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