More boards are tying CEO raises to company performance

by Brett Lieberman
for Virginia Business
October 2005

During the lean early years as Capital One Financial Corp. was transforming from a spinoff of a Virginia bank into what would become one of the nation's largest independent credit card companies, top executives decided to forego their salary and bonus. Instead, they opted for performance-based stock options — betting that the business model could succeed. If the company performed well and the stock's value increased, they could cash out and get paid; if it didn't, the executives were out of luck. In 2004, the company enjoyed earnings of $1.5 billion — up 36 percent over the previous year — and earnings per share have grown 20 percent annually for 10 years running, a record few public companies can match. CEO Richard Fairbank took home zero salary or bonus but realized $56.4 million in stock gains, making him Virginia's highest paid CEO of a large public company in 2004.

This philosophy of tying executive pay to a company's actual performance is a growing trend. Instead of CEOs saying, "Show me the money," boards and shareholders are turning the tables, demanding to know if executives can show them the skills that increase a company's value.

It's all part of a rebalancing of executive compensation, which follows years of pressure from governance groups, shareholders and the media after high-profile corporate scandals. With highly paid CEOs such as WorldCom's Bernard Ebbers drawing jail sentences for their roles in accounting frauds, boards are increasingly nervous about handing out excessive rewards. "This is not an easy process and they are getting better at it, but the link between pay and performance this past year is the closest I've ever seen it in the 27 years I've been studying compensation," says Steve Harris, a partner at Mercer Human Resource Consulting in Atlanta.

An annual Mercer study of 350 major U.S. corporations found that median annual salaries and bonuses for CEOs rose 14.5 percent last year while median total direct compensation was up 17.1 percent to $7 million. At the same time, shareholders saw a median total return of 17.4 percent and corporate profits were up 23 percent — their highest increase in 10 years.

Pay for performance can be good news for executives at fast-growing companies or in hot sectors, especially during a strong market. However, the practice is not limited to technology or similar industries, often seen on the cusp of trends. Smithfield Foods' CEO Joseph W. Luter III made $850,000 in salary last year, with the serious pork in his bacon coming from a $9.8 million bonus, derived from a formula based on companywide profits. The country's largest pork processor reported record sales of $11. 4 billion for the fiscal year that ended May 1. In fact, it has been so pleased with its performance during its 30th anniversary year that Smithfield updated a chart on its Web site showing that an investment of $100 in the company three decades ago would be worth $105,600 today. The chart's headline: "This Pig Keeps Flying."

More than half the highest paid CEOs at Virginia largest companies earned more in bonuses than in base pay last year. Not only are boards changing benchmarks for how they reward executives, but also the mix of options — from stock and long-term incentives to cash — is changing. Increased scrutiny by regulators and auditors post Sarbanes-Oxley, and the fear of court cases has led boards to be more cautious about quickly rewarding executives, who haven't delivered the goods.

One obvious, yet subtle change is the hiring of the compensation consultant. This person used to be hired by the CEO to make a presentation to the board. Now more often than not, the compensation committee hires the consultant to work with the CEO. The consultant's loyalty is to the compensation committee, so he or she doesn't have to worry about being fired by the CEO for backing a lower pay deal. "They are spending more time and energy and trying to really do the right thing," says Bruce R. Ellig, the former board chairman of the Society of Human Resource Management in Alexandria. "It's difficult sometimes," adds Ellig, who consults for boards and is author of The Complete Guide to Executive Compensation, "because the CEO is the person who brought them on board, and you're perceived as turning against somebody who brought them on board."

Still, having an independent consultant makes it easier for the compensation committee to get candid information. Executives, particularly those in high-demand sectors, still have the leverage to command top dollar and negotiate compensation packages that include golden parachutes, merger clauses, stock and other incentives. For instance, the competition for talent among government contractors in Northern Virginia for software and IT executives is leading to larger base salaries plus bonuses in excess of 100 percent of salary or more. "The candidates recognize that they are in the drivers' seat and that has forced organizations to increase the base and bonus packages," says Robert McHale, a senior client partner in the Tysons Corner office of executive search firm Korn/Ferry International.

On the other hand, shareholders continue to steam over "paying a lot of money to people who are perceived to have failed in their jobs," says Mercer's Harris. David Siegel, for example, received a $6.3 million severance package when he quit last year as CEO of US Airways, an airline trying to recover from Chapter 11 bankruptcy. Still, severance deals remain a valuable recruiting enticement that provides executives a degree of safety in case of merger or a bad fit, says Mercer's Harris.

With fewer public offerings in recent years, mergers and acquisitions have become more common ways for companies to grow. "As that consolidation occurred, all of a sudden executives found they were two in a box. Suddenly there were two CFOs, two CEOS and two VPs of sales," says Korn/Ferry's McHale. "Typically the person being acquired was a person who suddenly found themselves on the outs."

Executive agreements frequently include "change of control clauses" that offer severance plus automatic stock option vesting as a way to compensate those tossed aside. In Siegel's case, US Airways' board bolstered his severance deal in 2003 to keep him at the struggling airline at least another year.
While a handful of severance packages generate publicity for their extravagance, most executives don't have golden parachutes. The typical deal guarantees salary for six to 18 months — assuming they were not let go for cause — and depend on the executive's position.

Companies also are also looking for new ways to compensate executives. Unrestricted stock options have lost their luster after several years of volatile markets but are regaining some popularity as stocks continue to perform better. At one time, unrestricted stock options were like a free lunch to companies since they didn't cost anything until they were exercised. That's changed now as new rules force employers to expense options. It's not just an issue for paying top executives either because the majority of stock options go to workers below the five highest paid executives — mid-level executives and rank-and-file workers.

Restricted stock offerings, which have at least three gradations, have become more popular compensation alternatives. What Ellig calls "The Survival Award" grants stock to executives who remain with the company for a preset period, but this practice is unpopular with many stockholders because it has no performance requirement. "You have to inhale and exhale for five years. At the end of that period the money is yours," he says.

Performance accelerated plans typically vest after a period of about eight years, but restrictions could be lifted if the company achieves an agreed-upon compound growth rate for any three-year period. While requiring some performance guarantees, the restrictions could lapse in as little as three years.

Some companies are now moving into performance share plans, which came into vogue originally as a compensation tool during the flat stock markets of the late 1960s and early 1970s. These plans change the number of shares an executive will or will not receive after a stated period of three, four or five years depending on the company's performance. It can provide a continued incentive for good leadership but doesn't necessarily lapse quickly.

A number of companies are also beginning to look at tandem stock options, which allow executives to choose from two option plans or a combination of them. For example, a CEO might choose between 100,000 stock options based on today's price and 150,000 options that would increase in price $1 per year. If the stock price remains flat, he might take more of the flat-priced option. But if the stock soars, he might take more of the graduated option because he could receive more shares.

And just as the Capital One executives had a vested interest in the company's performance, compensation committees are increasingly demanding that top executives and particularly CEOs retain a certain level of stock. The Mercer study found 64 percent of companies now have stock ownership guidelines for executives, an increase from 58 percent a year earlier. Nearly half of the companies have stock ownership guidelines for corporate directors as well.

While it's premature for governance groups and shareholders to declare victory in their fight over excessive pay packages, compensation experts think the pendulum is at least swinging in the right direction. "Companies have learned what a good result has looked like," says Harris. "We're going to measure future payments and results against that. We've reset the baseline at a much more responsible measure." That might not be much comfort to white-collar workers who last year received pay raises ranging from 3 to 3.6 percent, but it's a start.