BusinessWeek (Investing Section): September 23, 2009

CEOs and the Pay-for-Performance Puzzle
Many shareholders and corporate boards agree that our system of paying CEOs is broken. How best to reward good corporate chiefs and discourage bad ones?

By Ben Steverman

A highly skilled CEO is hard to find. Highly paid CEOs, however, are everywhere you look.

For decades, corporate boards, watchdogs, regulators, and shareholders have argued over the best way to reward corporate leaders for a job well done, while not overpaying mediocre chief executives.

They might not be any closer to solving this pay-for-performance puzzle. But, the extent of the financial crisis and recession has made the problem clear.

The public and politicians have noticed the huge severance packages for executives resigning for poor performance, or the billions of dollars in bonuses awarded just months before financial firms collapsed.

As a result, Congress, the Federal Reserve, and the Securities & Exchange Commission are all considering moves designed to limit excessive pay.

Reining In Compensation
Corporations seem to have gotten the message. On Sept. 21, a Conference Board task force made up of Big Business heavyweights recommended corporations take steps to rein in compensation packages. The task force’s first guiding principle: “Establish a clear link between pay, strategy, and performance.”

Irking many shareholders and policymakers is that last year’s poor performance is having only a small impact on pay.

The Corporate Library’s 2009 CEO Pay Survey, issued Sept. 23, showed that median total annual compensation for executives in the S&P 500 declined 0.08% in 2008. Three-quarters of CEOs saw their base salary rise, and only 3% got a salary cut.

Shareholders, however, did far worse: The Standard & Poor’s 500-stock index fell 37.6% in 2008.

“Many, many [companies] complained about missing targets” last year, says Paul Hodgson, Corporate Library senior research associate. “But [there were] very few where we saw a significant impact on bonuses.”

Oxy’s Irani, Apple’s Jobs Get Results
A longer time frame can sometimes help justify high pay. For example, Occidental Petroleum (OXY) Chief Executive Ray Irani has pulled in $341.1 million in compensation in the last 10 years, according to data provider Capital IQ. (Capital IQ’s compensation measurement includes cash compensation and stock awards, but excludes stock options.) But his shareholders have been rewarded, with their shares up 580% in the last decade, and $54.5 billion has been added to Occidental’s market capitalization.

Apple’s (AAPL) Steve Jobs can boast of more cost-effective results. He has earned $162.3 million in the last 10 years, but Apple stock is up 860% in that decade and $153.4 billion has been added to Apple’s market value.

But for every Jobs or Irani, there is a Jeffrey Immelt. The General Electric (GE) chief executive has earned $125.5 million in the last decade, but shareholders have seen GE’s market cap shrink $217 billion and their shares have fallen 58%.

(See the attached slide show for more examples of CEO pay and performance over the last decade.)

Short-Term or Long-Term Performance?
Infuriating to the public and even many compensation experts is the process by which CEOs profit while their companies do well, but are protected when they do poorly.

“You can’t just have the executive enjoy the upside,” says Aditi Mohapatra, an analyst with Calvert Investments, a socially responsible investment firm that has focused on reforming executive pay schemes. “Along with shareholders, they have to experience the downside as well.”
The concept of performance can be hard for boards to define. Should measures be short-term or long-term? And compared to what?
Irani can claim a job well done, but there’s no doubt his firm benefited from rising oil prices. The Corporate Library notes that seven of the 10 highest-paid CEOs in 2008 were petroleum executives.

Corporate boards may set short- and long-term objectives for their executives to meet. But a crisis, a recession, or even an unexpected boom can make those benchmarks irrelevant. Setting long-term goals is especially difficult in a volatile environment like this one, says Don Lindner, manager of executive compensation for WorldatWork, a nonprofit association of human resources professionals focused on compensation issues.

Golden Parachutes Out of Fashion
Lindner says corporate boards are spending much more time these days crafting compensation plans. They’re ending much-criticized “golden parachute” payments and shifting rewards from short-term goals to long-term accomplishments.

“I don’t think you’re going to see pay go down,” he says, “but you’re going to see a better alignment between pay and performance.”
Investors such as Brian Washkowiak of Talon Asset Management say vaguely worded compensation policies—which lack specific benchmarks or goals—can be a dangerous sign that a company is poorly run. “We’re trying to find management teams that are better aligned with shareholders,” Washkowiak says.

William Rutherford, president of Rutherford Investment Management, agrees. “When you see excessive compensation packages, you become concerned about the governance of the company,” he says.

High pay—or big bonuses—can give executives an incentive to take big risks or even distort results, Rutherford says.

“Say on Pay” Proposals
One proposed solution is to have shareholders conduct a nonbinding vote each year on a public company’s compensation package. That’s the proposal in front of Congress. On Sept. 18, Microsoft (MSFT) voluntarily agreed to a “say on pay” vote every three years. On Sept. 21, General Mills’ (GIS) shareholders narrowly approved a nonbinding resolution urging its adoption of a similar proposal.

Shareholder votes might make boards pay more attention to how they’re compensating executives, but they don’t solve the many difficulties inherent in pay packages.

Setting goals, particularly long-term goals, is difficult in an uncertain world. Companies and shareholders love to reward successful executives, but they’re also reluctant to punish leaders when times are tough—for fear of scaring off good managers when they’re needed most. The same incentives that reward good performance can also reward excessive risk-taking.

Finally, as the last couple of years have shown, so much—both good and bad news—remains beyond the control of a chief executive. To be sure, corporate chieftains can typically boast of advanced academic degrees and lengthy industry experience. These are clearly smart people. But in the volatile world of the 21st century, luck has a nasty habit of trumping skill—and CEOs are no exception.

See the attached slide show for examples of 25 well-paid CEOs and their track records over the last decade.

Steverman is a reporter for BusinessWeek’s Investing channel.