The executive pay system is broken

Banks had failed, the economy had slumped and the country was waging a costly war abroad. Yet executives continued paying themselves princely sums, forcing the president of the United States to speak out:

“No American citizen ought to have a net income, after he has paid his taxes, of more than $25,000 a year,” he said, urging Congress to help him “keep personal and corporate profits at a reasonable rate, the word ‘reasonable’ being defined at a low level.”

This wasn’t Barack Obama. It was Franklin Delano Roosevelt in 1942, only a few months after the attack on Pearl Harbor.

Compensation ? especially for the highest paid ? has been controversial for almost a century.

But after a year in which Wall Street firms paid $18.4 billion in bonuses while accepting more than $50 billion in government bailouts, many experts say the system may have finally blown itself apart.

“The system is broken,” said Warren Batts, former chief executive of Tupperware Corp., Premark International and Dart Industries who used to sit on the boards of Allstate Corp., Sears, Roebuck and Co. and Sprint. “It needs some guiding principles.”

Without such guideposts, executive pay has run amok. CEOs made 344 times more the average worker in 2007, according to a survey from United for a Fair Economy, which targets economic inequality. That’s up from less than 150-to-one in 1992.

In 1988, the value of “mega-grants” of equity for CEOs averaged $1.47 million. By 2003, the average equity grant was worth $3.3 million. But the mega-grants of the late 1980s were one-off awards. Fifteen years later, CEOs were getting 2.2 times as much every year, according to consulting firm The Delves Group.

Perks, such as country club memberships, corporate jets, palatial offices and rich retirement packages, have multiplied.

Despite the system’s goal of encouraging stronger performance, some companies, such as Washington Mutual, move the goalposts when targets may be missed to make sure their CEOs still get hefty rewards.

In the wake of the failure of WaMu and Lehman Brothers, some say the system may have spun so far out of control that it pushes executives to adopt strategies that damage the companies they run, rather than improve them.

Berkshire Hathaway Chairman and Chief Executive Warren Buffett said this month that the main cause of the current financial crisis was excessive compensation, which encouraged executives at financial institutions to take on too much leverage.

“The crisis exposed flaws in exec compensation, showing the system encouraged risk-taking without an appreciation of the ramifications, which in some cases were entity threatening,” said Bob McCormick, chief policy officer at corporate governance advisory firm Glass Lewis. “In good times, executives get paid extremely well and in bad times they get paid just very well.”

Buffett blamed large institutional shareholders for not speaking out enough against lavish CEO pay. He also fingered directors for rubber-stamping compensation plans and consultants for helping companies exceed the excesses of rivals, year after year.

And yet some of these players already know there are problems.

An April 2008 survey of 162 company directors and 72 institutional investment firms by consulting firm Watson Wyatt found that three-quarters of respondents thought the current system had hurt the image of American corporations.

Eight-six percent of investors said the system had led to excessive executive pay and 61 percent of directors agreed.

Less than two-thirds of the directors said the system improved corporate performance, while less than 40 percent of the investors thought that.

So if directors, investors and consultants know things need to change, why haven’t they?

Executive compensation expert Jesse Brill says the main problem is that directors find it very difficult to tell CEOs they’re paid too much ? even if they believe it.

CEOs often pick board members and some spend more time picking members of the compensation committee than other directors, Buffett said.

“The comp committee doesn’t want to offend the CEO,” Brill explained. “They don’t want to say ‘we love everything you’re doing, but in hindsight we did stuff with your comp that needs to be changed.'”

“Directors I’ve spoken with are very apprehensive about having these types of talks with CEOs,” he added. “It’s very awkward.”

Outside consulting firms survey what rival companies pay and this information is used to make sure CEOs get more than average. When this is repeated over and over, executive compensation rises inexorably.

These consulting firms are usually hired by the company, not the compensation committee. That often means they try to keep the CEO happy so that they don’t lose a valuable client, Brill said.

Then there’s the small army of internal and external lawyers telling CEOs that their pay packages are legal, Brill explained.

“All these different advisers cannot afford to say things directly in terms of what needs to be changed because they’re saying this to the person paying their paychecks,” Brill said. “That’s very powerful.”

What upsets Brill most is that the system preys on the vulnerabilities of human nature. Most CEOs aren’t greedy and care a lot about the health of the companies they run, he explained.

“But when consultants and lawyers are telling them they’re fine and in line with competitors, and the board is telling them ‘we want you to take this money,’ it makes it very hard for CEOs to say they don’t want the money,” Brill added.

Still, some CEOs are turning down parts of their big pay packages.

Best Buy Chief Executive Brad Anderson asked the board of the electronics retailer not to give him any long-term incentive award in 2008. In recent years, he’s also requested that his stock options go into a pool for other employees.

At Costco Wholesale, the annual salary of Chief Executive James Sinegal has been set at $350,000 since 1999 and cash bonuses have been generally capped at $200,000 since 1997. Sinegal also tries to link his bonus to those of other employees who are eligible for bonuses at the big-box retailer.

Walt Disney Co. Chief Executive Robert Iger turned down an extra $2.4 million that he was supposed to get because of the entertainment company’s fiscal 2008 performance. He asked the compensation committee not to give him the extra cash, although he still ended up with a $13.9 million bonus.

The fact that some CEOs have to turn away compensation that’s due to them in their contracts shows even more how the system is broken.

It wasn’t always like this.

From the Great Depression until the late 1980s, CEO pay levels stayed fairly constant. Adjusted for inflation, a CEO in 1988 earned as much as one did in 1934, according to research published in 1990 by Michael Jensen and Kevin Murphy.

The two compensation experts re-visited the issue in 2004 in the wake of the Enron scandal and concluded that things had changed “dramatically” for the worse.

“We are confident that the causes are systemic,” they wrote. Without “the creation of a new regime in compensation practice” more companies could get into trouble because of skewed incentives, they added.

So why has CEO pay surged so dramatically since the late 1980s? Many experts blame the following: Golden parachutes, annual stock-option grants, peer-group comparison surveys and reaction to new government regulations.

Golden parachutes first unfurled when CEOs faced high-stakes showdowns with corporate raiders during the 1980s leveraged buyout boom. Average parachute-values weren’t that outrageous at the time. But a provision in the 1984 Deficit Reduction Act put a special excise tax on parachute payments exceeding three times pay.

Boards took notice. They saw the new law as justification for golden parachutes and raised them to the maximum level. The agreements flourished to the point where even CEOs fired for incompetence were paid.

By 2000, 70 percent of the largest U.S. public companies had change-in-control agreements, up from 41 percent in 1988, and 57 percent in 1996, according to Jensen and Murphy.

Stock options thrived throughout the 1990s.

While boards saw options as a reasonable incentive for the CEO to grow the stock price and become a bigger owner of the business, options also fell outside an IRS rule from the 1994 Omnibus Reconciliation Act. The law said corporations couldn’t deduct non-performance pay of over $1 million from their taxes reported to the IRS.

Any company that didn’t pay its CEO $1 million a year in base salary quickly raised it to this level. The law also made options a bigger part of compensation as companies looked for ways to pay executives that complied with the tax rule.

By 2002, the dot-com bubble had burst and accounting scandals at Enron and WorldCom tarred stock options. Regulators told corporations they had to expense options. This made them more costly to carry on the books, eating into reported profits.

Enter restricted stock: Those grants grew in number to CEOs. Restricted stock usually vests over a three-year period. However, unlike stock options, restricted shares still have value even if a company’s stock price falls.

“It further weakened the link between pay and performance,” said executive pay consultant Jack Donnell-McConnell.

CEO pay surveys have ratcheted up total compensation and other goodies, according to corporate governance experts and those who have sat in boardrooms.

“CEO perks at one company are quickly copied elsewhere. ‘All the other kids have one’ may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument,” Buffett wrote in Berkshire’s 2006 annual report.

The combination of consultant surveys and huge stock-option grants was a particularly potent fuel for the executive compensation fire.

So-called mega-grants that became popular during the late 1980s were one-off awards. However, consulting firms began including them in their annual surveys, which formed the basis for companies setting up new compensation plans. In this way, large option grants became an annual affair, significantly boosting overall CEO pay.

The current financial crisis has been so severe and has exposed so many flaws in the executive compensation system, that many experts in the field are optimistic real changes may take hold.

“It’s not completely broken but its shaky foundations have been exposed more than ever before,” Glass Lewis’s McCormick said. “Shareholders not scared to shake them further.”

One important shift McCormick has sensed in recent months is that fewer investors are willing to give directors the benefit of the doubt when judging how well they’ve set executive compensation.

Buffett said excessive CEO pay could be limited if only a few of the largest institutional investors speak out publicly against egregious cases and “demand a fresh look at the whole system.”

Brill suggests three changes that he says would help restore public trust in the system by expunging several of the most offensive aspects of CEO compensation.

He recommends that companies eliminate severance for CEOs. When a new CEO is brought in ? and has given up a lot of future compensation from their previous employer ? a severance package lasting roughly three years is acceptable. However, such agreements should “sunset” after that.

“Once the CEO has accumulated a sufficient nest egg, there’s no need for a severance pension plan or change of control payouts,” Brill explained. “This type of post-retirement provision is a huge issue that needs to be addressed.”

Stock options and restricted stock should not be granted annually, Brill said. Such awards should be set up for CEOs once and left, like “a pot of gold at the end,” he explained.

Currently, many companies give large stock option grants to CEOs every year, even though the executives may already have huge awards from previous years.

“The CEO is likely to be already so motivated by stock price performance that new grants add no incremental motivational value. They only add cost,” long-time compensation consultant Fred Cook said during a 2005 speech to corporate directors.

CEOs have already been given so much equity ? through stock options and restricted stock ? that it may be difficult to limit excessive pay without trying to get executives to give up some of their awards.

Brill said it’s probably impossible to persuade CEOs to do this. Instead, companies should require that executives hold all the equity they’ve received for two years after they retire, he explained.

This will encourage CEOs to focus on longer-term strategies to boost the performance of the companies they run, rather than potentially riskier short-term tactics, Brill added.

Even some major compensation consultants agree that changes are needed.

Ira Kay, director of Watson Wyatt’s compensation practice, said companies need to be extremely flexible about executive severance packages, which can sometimes amount to “pay for failure.”

“Irritants” such as supplemental CEO pensions and perks should also be reconsidered, he added.

However, Kay stressed that the “core” of the current executive compensation system isn’t broken and needs to be protected.

“Our research indicates that the core stock and cash incentives are working. There is in fact pay for performance,” he said. “If a company thinks its main incentives are working, they need to defend them against all critics.”

Brill says several companies and boards have told him that they’re willing to make drastic changes in the way they pay CEOs and other executives. However, no one wants to be the first, he added.

“Companies are loath to go out on a limb and be too different from their competitors,” said Donnell-McConnell.

Such reticence prevents Brill from getting too carried away about the future.

“I am hopeful,” he said. “CEOs and board members are good people who care very much about their legacies and doing the right thing. If one can truly reach them I am optimistic that things can change.”

“But right now things have not changed much,” he added.

(c) 2009, Inc. Source: McClatchy-Tribune Information Services.