CEO Pay in the Post-Meltdown, Pre-Obama Era

The recent meltdown on Wall Street has brought CEO pay back to the forefront of business news, and the election of Barack Obama might help to keep it there for a while. Things had quieted down a bit in recent years since Sarbanes Oxley was enacted and the SEC implemented its new disclosure rules, but once again shareholders are up in arms about CEOs getting huge payouts while their companies disintegrate around them.

In 2007, the top highest-paid CEOs in the U.S. took home a combined $637 million. In 2004 that number was $309 million (DeCarlo, 2008). The average annual compensation for CEOs at 386 Fortune 500 companies in 2007 was $10.8 million, more than 344 times that of the average U.S. worker (Anderson et al., 2007). Astronomical numbers such as these, coupled with a plummeting stock market, federal bailouts, and an overall down economy, have intensified the scrutiny on CEO pay.

But one of the ironies is that many CEOs have taken a serious hit to the wallet in recent months, since much of their compensation consists of stock vehicles. According to research from consulting firm Steven Hall & Partners, the corporate stock holdings of CEOs at 175 large U.S. companies have dropped in value by 49% since the beginning of the year (Associated Press, 2008).

And some of the CEOs in failed organizations have been paying a price. Richard Fuld, CEO of Lehman Brothers when it went into bankruptcy, was set to receive a retirement package consisting of $16.8 million in pension benefits and $5.6 million in deferred compensation. According to lawyers for the investment firm, Fuld will be terminated at the end of 2008 and receive no bonus or severance. A spokesperson for Lehman Brothers said that Fuld himself made the offer to stay on through the transition and forgo his severance (Sandler & Scinta, 2008).

Roger Wilumstad, who was the CEO of AIG for just three months this year, was eligible to receive a severance package worth around $22 million, but he declined to accept the payment in light of the fact that “shareholders and employees have lost considerable value in their AIG shares.” The financial mess prompted Fuld, Lehman Brothers’ president Bart McDade and Washington Mutual’s former CEO Kerry Killinger all to turn down bonuses (Gomstyn, 2008).

To many, these tales of sacrifice don’t exactly tug on the heartstrings. Killinger still managed to take home a severance package worth $22 million when he stepped down in August. Stanley O’Neal, former CEO of Merrill Lynch, saw none of his compensation affected when the company reported net losses of $10.37 per share in 2007, and he received his full $160 million retirement plan when he resigned in October of that year.

It will be interesting to see how the discussion about CEO pay evolves in the market-collapse era before President-elect Obama takes office. Many have historically argued that CEO pay is not out of line. A study from compensation consulting firm DolmatConnell & Partners found that, from 1997 to 2006, CEOs at the companies within the Dow Industrial Average saw their median base salary increase by 9.6%, short-term incentives by 18.2% and long-term incentives by 14.3%. During that same time, revenue at these firms was up 14.7%, market capitalization 14.7%, net income 14.4% and total shareholder return 12.1% (“Debunking,” 2008). This seems to indicate that CEO pay was in line with performance.

Steven Kaplan, professor of entrepreneurship and finance at the University of Chicago Graduate School of Business, believes that CEO pay is purely market-driven. He testified to Congress that U.S. CEOs are not overpaid, that they are in fact paid for performance, and that boards are not conspiring to inflate CEO pay. Kaplan points to how strong the U.S. economy has been over the past two decades to suggest that companies have been well managed. He also notes how the CEOs of Citigroup, Merrill Lynch and Bear Stearns all lost hundreds of millions of dollars when their stock prices plummeted (Kaplan, 2008).

But others have argued just the opposite. John C. Bogle, founder and former CEO of The Vanguard Group, points out that, overall, corporate profits have remained a relatively constant percentage of GDP, yet CEO pay has increased exponentially. Bogle and others put much of the blame on the shoulders of corporate boards and the compensation consultants they hire. Boards rarely want to see their CEO in one of the lower quartiles of CEO pay, so the pay gets inflated until it falls into one of the top two quartiles.

This then knocks another CEO into the lower quartiles, and it starts all over again. This ratchet effect is aided by consultants who not only want to keep working as compensation consultants but also have their consulting firms hired by CEOs for other work (Bogle, 2008).

Now Congress may want to enter the debate. Not only has there been a call to put a cap on executive pay for companies involved in the $700 billion bailout, some proposals call for increasing shareholder input in compensation decisions and in the election of board members (Sward, 2008).

Whatever the final outcome, it’s unlikely that this storm will pass without some sort of regulatory influence on CEO pay. The House passed a bill in 2007 allowing shareholders to approve or disapprove executive compensation plans to vote on golden parachutes given out during merger or acquisition talks. Barack Obama was a sponsor of similar “say-on-pay” legislation in the Senate, and his election as president (along with Democratic gains in Congress) make it even more likely new regulations will emerge.

But even if Congress does take steps, those actions may not have the desired effect. When Congress passed a law that lowered the amount of executive salary eligible for a tax deduction to $1 million, for example, companies simply made that the base salary cutoff and filled in the rest with stock options, effectively shooting executive pay even higher (Sward, 2008). Many analysts believe the SEC’s disclosure rules, meant to shame companies into reeling in CEO pay, actually made it easier for CEOs to compare pay packages and demand even more.

With all this in mind, companies need to pay even closer attention to the pay packages they are developing. Influencing these decisions can be difficult without a seat on the compensation committee, something HR has not always had. Oftentimes an HR director who reports to the CEO may have a hard time being impartial when it comes to setting that CEO’s pay.

There are a few things a company can do to help develop what many will see as a sensible and fair executive compensation package:

• Make sure the pay package is consistent with the overall corporate compensation strategy.
• Ensure performance goals align with corporate goals.
• Do not rely too heavily on short-term incentives such as stock options, which can encourage risky behavior that reaps immediate rewards but also risks disaster in the long run.
• Include provisions for returning compensation in light of restated earnings.
• Ensure that severance and retirement packages are contingent on performance and not simply a golden parachute that deploys no matter the circumstances.
• Examine perquisites to gauge the public reaction if the perks must be disclosed in SEC filings.

Documents used in the preparation of this TrendWatcher include the following:

• Anderson, S., Cavanagh, J., Collins, C., Pizzigati, S., & Lapham, M. (2007, August 29). Executive Excess 2007. Institute for Policy Studies/United for a Fair Economy.
• Associated Press. (2008, November 3). Not only the little guy hit by market’s plunge. St. Petersburg Times, pp. 1A, 12A.
• Bogle, J. (2008). Reflections on CEO pay. Academy of Management Perspectives, 21-25.
• Debunking the myth of runaway CEO pay. (2008, January). workspan, 12.
• DeCarlo, S. (2008, April 30). Top paid CEOs. Forbes.com. Retrieved from forbes.com
• Gomstyn, A. (2008, September 23). AIG CEO rejects $22 million parachute; will others follow? abcNews.com. Retrieved from abcnews.go.com
• Kaplan, S. (2008). Are U.S. CEOs overpaid? Academy of Management Perspectives, 5-20.
• Sandler, L., & Scinta C. (2008, November 5). Lehman chief Fuld “terminated” by bankrupt company. Bloomberg News. Retrieved from bloomberg.com
• Sward, S. (2008, September 27). Political minefield over CEO compensation. SFGate.com. Retrieved from sfgate.com.