Executive Pay

Tying pay to performance is a great idea. But stock-option deals have compensation out of control

By Jennifer Reingold in New York, with bureau reports
Business Week

April 21, 1997

It seems to have worked like a charm. In recent years, as boards shifted the mix of executive pay away from cash and toward stock options, corporate profits and the stock market have vaulted to record levels. It's exactly the win-win situation that pay for performance was expected to bring: more reward for the leaders and better returns for shareholders, who can sleep well knowing that executives feel the same pain they do if their companies underperform.

It's a soothing lullaby, but shareholders are starting to wake up to some sour notes. The explosion of executive pay--propelled by huge option grants, easy performance provisos, and a bull market--has created a windfall for all. Star CEOs are winning big, but so are many second-stringers. Even for the success stories, the CEO's gains often exceed the company's own strong year proportionally. And while the mass embrace of options has helped shareholders, options have hidden costs and are diluting those gains to the tune of tens of millions of dollars.

Few doubt 1996 was a stellar year. The Standard & Poor's 500-stock index rose a stunning 23%. Corporate profits rose, too--an impressive 11%. Who would begrudge U.S. chieftains a healthy raise?

Apparently, no one. But many CEOs took that--and a good deal more. For 1996, CEO pay gains far outstripped the roaring economy or shareholder returns. The average salary and bonus for a chief executive rose a phenomenal 39%, to $2.3 million. Add to that retirement benefits, incentive plans, and gains from stock options, and the numbers hit the roof. CEOs' average total compensation rose an astounding 54% last year, to $5,781,300. That largesse came on top of a 30% rise in total pay in 1995--yet it was hardly spread down the line. The average compensation of the top dog was 209 times that of a factory employee, who garnered a tiny 3% raise in 1996. White-collar workers eked out just 3.2%, though many now get options too.

It all adds up to quite a payday--and one that's raising a storm of criticism. "We've got terrible tensions this year" with institutional investors, says Pearl Meyer, president of pay specialist Pearl Meyer & Partners. Even many shareholder advocates who pushed for the move to pay for performance in the early 1990s question whether the approach is working. As once-outsize options packages become the norm, many CEOs are taking the lion's share. Far smaller gains are going to managers and other key employees. The disturbing message: The CEO deserves nearly all the credit for the company's success. Worse, there's very little downside to many CEO pay deals. Many executives are negotiating big guaranteed payouts in case they stumble. And if the market drops, some pay experts worry that executives will demand--and get--options at lower prices to ensure that their pay packets remain full.

What are the main results of BUSINESS WEEK's 47th annual Executive Pay Scoreboard? Compiled with Standard & Poor's Compustat, a division of The McGraw-Hill Companies, the survey examines the compensation of the two highest-paid executives at 365 of the country's largest companies. In comparing pay with performance over three years, BUSINESS WEEK found that Microsoft's William H. Gates III and Avon Products' James E. Preston gave investors the best results for their pay (page 61). Conseco's Stephen C. Hilbert and America Online's Stephen M. Case were the worst-performing CEOs relative to payouts.

Despite the soaring pay, many experts argue that the system is working better than ever. They see the bull market and healthy corporate sector as proof positive that companies get what they pay for. They argue that as long as CEOs continue to turn in strong results for their shareholders, the absolute level of executive pay is irrelevant. "You can't legislate morality," says James E. McKinney, consultant at pay experts Hirschfeld, Stern, Moyer & Ross Inc. "The U.S. is the most exciting economy the world has ever seen." Adds Charles W. Sweet, president of A.T. Kearney Executive Search: It's simply "the cost of finding brains."

Little-Known Leader. In many cases last year, those brains cost a lot more. The top ranks were peopled by such corporate standouts as Intel's Andrew S. Grove, who earned $97.6 million, and Travelers Group's Sanford I. Weill, who made $94.2 million, most of which remains in Travelers stock that he can't sell until he retires. Heading our list for the second straight year was Lawrence M. Coss, the little-known CEO and chairman of Green Tree Financial Corp., based in St. Paul, Minn. Thanks to a five-year deal set in 1991 that paid him 2.5% of pretax income, Coss made $102.4 million last year--a 56% rise over the $65.6 million he earned in 1995.

By any standard, Coss's paycheck is huge. And for many investors and pay experts, he remains the poster boy for all that is right with pay for performance. Coss himself makes no apologies. "Indeed it is a huge number," he says, "but I'd rather talk about the success of the company." That's easy to do. Between 1991 and 1996, Green Tree's shares had compounded annual returns of 53% as it became the largest lender to the manufactured-home sector. Although two small pension plans recently sued Coss and the board for excessive compensation, most big shareholders appear satisfied. "In no way would I consider him overpaid," says Thomas W. Smith, partner at Prescott Investors Inc., which holds 2.7 million shares.

Like Coss, most well-paid execs point to stock gains as proof that their pay is richly deserved. Ask Sam Wyly, chairman of Sterling Software Inc., about the fact that his $439 million company produced three of the biggest pay packages in Corporate America last year, and he lets out a belly laugh. "We should," he says, pointing to the company's 673% stock price rise since its 1983 initial public offering. The payouts--which totaled $69.6 million for Wyly, $34.7 million for his brother, vice-chairman Charles J. Wyly Jr., and $58.2 million for CEO Sterling L. Williams--came mostly from option exercises.

Yet if few would dispute the success of such fast-growing companies, investors are increasingly asking how much is enough to get top performance. Again, take Coss. His pay is so gargantuan that it dwarfs his stellar performance. The ratio between his three-year pay and the shareholders' return puts Coss third on BUSINESS WEEK's list of CEOs who gave shareholders the least for their buck. Moreover, the huge award significantly diluted other shareholders' gains: Coss's payouts cut Green Tree's 1996 earnings 16%, to $308.7 million.

Because he received shares directly, rather than options, Coss's compensation differs from that of most CEOs. But as the sheer number of options has soared, shareholder dilution is proving an unanticipated by-product. Companies use options in part to align executives' interests with shareholders. But they also favor them because--unlike other forms of pay--they never show up on an income statement. Instead, starting this year, companies must footnote them in their annual reports using the Black-Scholes fair value option pricing model.

It takes some digging, but those footnotes provide plenty of surprises. For all the benefits that options create, they're not free. PepsiCo Inc., for example, reported that its option grants would have reduced earnings by $68 million, or 6% last year, had they been counted as compensation. Medical-equipment maker Guidant Corp.'s earnings after charges would have taken an 11% hit. By putting more potential shares into circulation, options reduce every shareholder's slice of the earnings pie. And because the footnotes include only options granted since 1995, Bear, Stearns & Co. accounting analyst Pat McConnell estimates they understate the impact by at least 50%.

Concerned Investors. Companies with broad-based option plans say the dilution is a small cost next to the benefit of motivating employees. But the largest share of those new options goes to the corner office. According to Executive Compensation Reports, a Fairfax Station (Va.) newsletter and database, 51% of companies that have reported granting options for 1996 have given 10% or more of them to the CEO. In 1993, only 18% of companies did so.

But that's not the only hidden cost of options. Companies have been buying back shares in record numbers, even as many sell discounted shares back to executives when they cash in their options. With many shares trading near record highs, those companies are paying top dollar to buy back stock--while execs pocket the aftertax difference between the option price and the market price. That often results in large cash outlays, and it also means executives end up with an ever higher percentage of outstanding shares. "Want to talk about the largest social welfare transfer program in the world?" says Patrick S. McGurn, director of corporate programs at Institutional Shareholder Services Inc., a proxy advisory service based in Bethesda, Md. "It's from shareholders into the pockets of executives."

So far, investors have been relatively quiet on dilution. But now they're taking notice. Institutional Shareholder Services is recommending "no" votes against at least 20% of new stock-option plans, including those at Starbucks Corp. and Sprint Corp. And the five New York City pension funds will oppose some one-third of plans this year, primarily because of concerns over dilution. Options "do come home to roost," says Jon Lukomnik, New York City Deputy Controller for pensions.

Another unwelcome result of the shift to pay for performance: It's not just the best who are pulling in giant pay. Performance targets are often set so low--or so loosely--that they're virtually meaningless. "Performance criteria are almost like intellectual Silly Putty," says Warren Bennis, Distinguished Professor of Business Administration at the University of Southern California's Marshall School of Business.

According to Executive Compensation Reports, of proxies examined so far this year, only 6.6% of option-granting companies issued any "premium-priced" options--those with prices above market value on the day of issue. And though the number is up from last year's 3.5%, most companies boasting premium-priced options make them only a small portion of the package. Just 20% of PepsiCo CEO Roger Enrico's 1.7 million stock-option awards in 1996 were made at prices above then-current market value, for example. And of last year's record-setting grant of 8 million options to Walt Disney CEO Michael D. Eisner, only 3 million were awarded at above-market prices.

Shareholder advocates say that tougher targets are necessary to keep from rewarding average CEOs who are simply riding a bull market. Nell Minow, a principal in LENS, an activist investor group, argues, for example, that executives should outperform the market or their peer group to receive big packages.

Instead, with grants in the hundreds of thousands of shares now commonplace, managers can earn a big payday even if their stocks rise only slightly. In Eisner's case, if Disney shares rise a tiny $2 annually--a poor performance by Disney's standards--the value of his market-priced options would increase $10 million annually. And there's little real downside. Few executives suffer financially if the stock drops. "One of my biggest complaints is there's not much risk'"with options, says Anne Yerger, director of research at the Council of Institutional Investors. "In a bull market, most executives are going to get money."

Losing the Balance? As a result, many execs whose performance trailed their peers' have also benefited. Typical was H.J. Heinz's Anthony F.J. O'Reilly, who made $64.2 million last year. His company's stock performance rose just 11%, trailing both the S&P and other food companies. O'Reilly defends his huge option grants as part of a generous incentive scheme. "There can be no more honorable or fairer way" to compensate CEOs, O'Reilly argues.

The staggering rise in pay for the good, the bad, and the indifferent has left even some advocates of pay for performance wondering whether the balance between the CEO and the shareholder is tilting the wrong way. "I've been consulting for over 20 years and have seen options accepted carte blanche as a good thing," says George B. Paulin, president of compensation consultancy Frederic W. Cook & Co. "Now, boards and investors are starting to question the structure of option deals."

In the meantime, many top execs have amassed vast troves of options that have yet to be exercised (page 66). Among those with the largest potential jackpots: Disney CEO Eisner, who holds some $364.4 million in unexercised stock options. The gains are so enormous that AOL's Case, who cashed in most of his $27.4 million in options before growing pains and accounting changes beat up the stock last year, is still sitting on options worth an additional $116.6 million. And topping the list is HFS CEO Henry R. Silverman, with $544.3 million in exercisable stock options.

The question, of course, is why boards don't set the performance bar higher. While compensation committees are much more vigilant than they've ever been, Kayla J. Gillan, general counsel at the California Public Employees' Retirement System, a $110 billion pension fund, points out that about 25% of the companies in the S&P still have an insider on the compensation committee. And companies fear they'll lose talent if their executive pay falls below that of their peers. That helps to inflate compensation. Says Howard B. Edelstein, a principal of the Todd Organization, a benefits consulting firm: "Companies are saying, 'Take me to the middle.'"

Despite recent requirements that boards disclose the criteria they use to set pay, there's plenty of wiggle room. At Mattel Inc., for example, newly named CEO Jill E. Barad wasn't eligible for a bonus in 1996 because the company missed internal targets. So instead, the board awarded her a $280,000 "special achievement bonus" for progress made in 1995. And like many executives, Barad has also negotiated protection should things at Mattel go wrong. If Barad is dismissed or leaves for "good reason," she'll receive five times her last salary plus average bonus, become vested in an executive retirement plan at the age of 50, and have a $3 million loan forgiven.

Seller's Market. Even those whose subpar performance makes their options worthless have recourse. For example, in 1995 Digital Equipment CEO Robert B. Palmer was granted 300,000 options at the then-market price of $48. The next year the package was smaller, but the exercise price fell to $37.75 to match the swooning stock. If the stock returns to its already depressed 1995 price, Palmer will pocket nearly $2 million.

Many consultants say companies, faced with executives who are more willing to job-hop, must dole out juicy options packages and guarantees to get the execs they want. It's a seller's market, with CEOs in demand holding most of the cards. "In many cases," says Peter T. Chingos, national practice director of compensation at KPMG Peat Marwick: "You don't have a choice."

And if the recent tremors in the stock market turn into an earthquake? With shareholder returns increasingly the gauge for setting executive compensation, the truest test of pay for performance may come in a bear, not a bull, market. Yet few expect CEOs, now accustomed to supercharged awards, to cut back. Instead, experts anticipate demands for lower-priced options or for more cash. "When stock prices go down [CEOs argue], it's purely the vagaries of the market," says Kevin Murphy, a professor of business administration at USC. "But when they go up, it's what they did to create value."

Already, the pressure to reprice has begun. After a difficult few years in the trucking industry, Jerry W. Walton, chief financial officer at J.B. Hunt Transport Services Inc. in Lowell, Ark., says he tried to get the top brass to reprice their options, which have fallen below market value, on condition that they surrender some of the stock. Included: a grant of 2.5 million options for Chairman Wayne Garrison. "Everybody thought it was a good idea to reprice," Walton says with a laugh. "Nobody thought it was a good idea to surrender [the options]."

Will executive pay ever descend from the heavens? Some who helped push the early-1990s reforms aimed at trimming exorbitant executive pay--and tying it more closely to performance--are cynical. "I wouldn't say the glass is half full; I'd say it's one-millionth full," says Minow. "I do think things have improved. But a lot of the reforms we thought would happen with executive pay have been ineffective." For shareholders, 1996 was a good year indeed. But it was a far better year for the boss.

The Top-Paid Chief Executives...

                              1996 SALARY  LONG-TERM        TOTAL
                                AND BONUS    COMPEN-         PAY
                                THOUSANDS    SATION
                               OF DOLLARS
1       LAWRENCE COSS            $102,449    none         $102,449

2       ANDREW GROVE                3,003   $94,587         97,590

3       SANFORD WEILL               6,330    87,828         94,157

4       THEODORE WAITT                965    80,361         81,326
        GATEWAY 2000

5       ANTHONY O'REILLY            2,736    61,500         64,236
        H.J. HEINZ

6       STERLING WILLIAMS           1,448    56,801         58,249

7       JOHN REED                   3,467    40,143         43,610

8       STEPHEN HILBERT            13,962    23,450         37,412

9       CASEY COWELL                3,430    30,522         33,952
        U.S. ROBOTICS

10      JAMES MOFFETT               6,956    26,776         33,732

11      JOHN CHAMBERS                $619   $32,594         33,213

12      STEPHEN WIGGINS             1,738    27,270         29,008

13      ECKHARD PFEIFFER            4,250    23,546         27,796

14      STEPHEN CASE                  200    27,439         27,639

15      JOHN WELCH                  6,300    21,321         27,621

16      RICHARD SCRUSHY            11,380    16,197         27,577

17      HENRY SILVERMAN             3,752    19,990         23,742

18      NORMAN AUGUSTINE            2,781    20,324         23,105

19      JOHN AMERMAN                3,732    18,923         22,655

20      DREW LEWIS                  3,131    18,320         21,452

...And Ten Who Aren't CEOs

                              1996 SALARY  LONG-TERM       TOTAL
                                AND BONUS   COMPEN-         PAY
                                THOUSANDS   SATION
                               OF DOLLARS
1       SAM WYLY                   $1,571   $68,036        $69,608

2       FRANK LANZA                 1,947    48,918         50,865

3       RICHARD KINDER              2,458    35,238         37,697

4       JAMES CROWE *               1,497    34,280         35,777

5       CHARLES WYLY JR.              816    33,870         34,686

6       JOE ROBY                   $8,773   $24,220        $32,992

7       SHIGERU MYOJIN             10,558    20,873         31,431

8       FRANK MARSHALL                490    27,879         28,369

9       WILLIAM RHODES              1,300    22,189         23,489

10      JOEL ALVORD                 3,040    19,409         22,449


Executives Who Gave Shareholders the Most for Their Pay...

                                   Total pay*   Share-   Relative
1994-96                             Thousands   holder    index
                                   of dollars  return**
1 WILLIAM GATES Microsoft              $1,436       310%      286
2 WARREN BUFFETT Berkshire Hathaway       904       109       231
3 THOMAS GOLISANO Paychex               1,475       238       229
4 MICHAEL BIRCK Tellabs                 3,369       537       189
5 RICHARD USSERY Total Systems Service  2,454       315       169

*Salary, bonus, and long-term compensation paid for the entire three-year 
period        **Stock price at the end of 1996, plus dividends reinvested for 
three years, divided by stock price at the end of 1993

...And Those Who Gave Shareholders the Least

                                     Total pay*   Share-   Relative
1994-96                               Thousands   holder    index
                                     of dollars  return**
1 STEPHEN HILBERT Conseco               165,223     133       1.4
2 SANFORD WEILL Travelers               156,166     146       1.6
3 LAWRENCE COSS Green Tree Financial    197,007     230       1.7
4 ANTHONY O'REILLY H.J. Heinz            68,179     66        2.4
5 JOHN WELCH General Electric            57,292     104       3.6

*Salary, bonus, and long-term compensation paid for the entire three-year 
period        **Stock price at the end of 1996, plus dividends reinvested for 
three years, divided by stock price at the end of 1993

Executives Whose Companies Did the Best Relative to Their Pay...

                                   Total pay*   Avg. return   Relative
1994-96                             Thousands     on equity     index
                                   of dollars
1 JAMES PRESTON Avon Products          $7,907         141%            107
2 B. THOMAS GOLISANO Paychex            1,475          28             102
3 WILLIAM GATES Microsoft               1,436          27             93
4 MITCHELL FROMSTEIN Manpower           10,415         32             84
5 C. RUSSELL LUIGS Global Marine        4,851          20             83

*Salary, bonus, and long-term compensation paid for the entire three-year 
period        **Stock price at the end of 1996, plus dividends reinvested for 
three years, divided by stock price at the end of 1993

...And Those Whose Companies Did the Worst

                                   Total pay*   Avg. return   Relative
1994-96                             Thousands     on equity     index
                                   of dollars

1 STEPHEN CASE America Online           33,460        -413          -226
2 ROBERT PALMER Digital Equipment       3,840         -25           -40
3 ANDREW LUDWICK Bay Networks           1,512          14           -39
4 JAMES ROBBINS Cox Communications      3,991          2            -13
5 JOHN ROACH Tandy                      3,967          7            -12

*Salary, bonus, and long-term compensation paid for the entire three-year 
period        **Stock price at the end of 1996, plus dividends reinvested for 
three years, divided by stock price at the end of 1993

Options: The Hidden Costs

In a footnote in this year's annual reports, companies are required to 
disclose--for the first time--the cost of options. Although current accounting 
rules treat options as cost-free, here's what a handful of companies would have 
to deduct from 1996 earnings if options were accounted for:

PEPSICO                 68
J.P. MORGAN             52
TRAVELERS               51
GILLETTE                47
MORGAN STANLEY          43
RAYTHEON                29
COMPAQ                  21
USAIRWAYS               15


Fortunes In the Future

These chief executives still have huge rewards to reap from stock options that have yet to be exercised. The top 20 treasure chests:

                     VALUE OF NONEXERCISED
HENRY SILVERMAN            $544,284

MICHAEL EISNER              364,360

CHARLES WANG                248,928

RICHARD SCRUSHY             188,044

STEPHEN HILBERT             145,860

ROBERTO GOIZUETA            134,059

WAYNE CALLOWAY              123,785

LAWRENCE ELLISON            121,178

STEPHEN CASE                116,592

DANIEL TULLY                111,387

JOHN WELCH                 $107,310

SANFORD WEILL               101,547

ECKHARD PFEIFFER            97,381

STEPHEN WIGGINS             81,514

LOUIS GERSTNER              81,183

STEVEN BURD                 80,938

LAWRENCE BOSSIDY            79,101

SCOTT McNEALY               78,228

CASEY COWELL                72,833

ANDREW GROVE                72,280

*Based on stock price at end of company's fiscal year

Which Bosses Earned Their Pay, and Which Didn't?

By Lori Bongiorno in New York, with bureau reports.

Microsoft Corp. Chairman William H. Gates III doesn't fuss about the size of his salary. In fact, he even jokes about lowering it. But as the software giant's largest shareholder, Gates certainly doesn't need a megapay package. His 23.7% stake in Microsoft is worth a colossal $27.7 billion. Salary or not, he comes out a big winner.

And his shareholders haven't done so badly either. Gates is one of this year's two pay-for-performance winners. A BUSINESS WEEK analysis shows that Gates gave shareholders the highest return relative to his pay. And for the second year, James E. Preston, chief executive of Avon Products Inc., delivered the highest return on equity (ROE) relative to his pay (table, page 60).

Network. Gates has driven Microsoft to develop one success after another. Windows 95, along with applications such as Office, lofted sales to $8.7 billion last year, up from $5.9 billion in 1995. Gates also engineered a wrenching change last year, making the Net central to all new products. Microsoft's Web browser, Internet Explorer, has now racked up more than a 20% market share. Since 1994, Gates's total pay has been just $1.4 million, while shareholder returns have jumped 310%.

Preston is the CEO whose company performed best relative to his pay. To align his pay with performance, Preston froze his $610,000 salary five years ago and began taking most of his compensation in stock options. Over the past three years, Preston has earned $8 million. Avon's average ROE is 141%. In part, that reflects Avon's renewed growth, although an aggressive stock-buyback program has also left Avon with a small equity base. This year, Preston's salary will jump to $1 million. But with $22 million in options yet unexercised, he insists he's still a big advocate of pay for performance. ''I will do well or not well depending on how the stock does,'' he says.

On the other side of the ledger, Conseco Inc.'s Stephen C. Hilbert gave shareholders the least for the $165 million he's collected since 1994. Most came from a $107 million stock-option exercise in 1994 and a $23 million exercise last year. Since 1994, shareholder return has been 133%. A company spokesman argues it's unfair to compare the value of Hilbert's options with performance over the past three years. He says it should be compared with the 3,100% return created over the 10 years since the first option grant. Adds Hilbert: ''I'm certainly not embarrassed about our success or mine personally.''

Stephen M. Case, CEO of America Online Inc., provided the worst corporate performance relative to his pay. During the past three years, Case earned $33.5 million, while the ROE was negative 413%. Most of his gains came from exercising $27.4 million in options last year. Last summer, the stock was driven down by growing pains and a restructuring to change AOL's controversial accounting practices. CFO Lennert J. Leader says AOL is concentrating on growing its customer base and revenues, as opposed to short-term profits. But as Case struggles to get AOL back in the black, the payoff--for the company, if not for him--appears far away.

Copyright 1997, by The McGraw-Hill Companies Inc. All rights reserved.