Human Capital & Careers

Battle Lines Drawn on Executive Pay

A House bill would require shareholder approval for corporate compensation policies.
Marie LeoneMay 26, 2006

In the increasingly contentious national debate over whether executives are being paid too much, the battle lines are becoming clear. At a House Financial Services Committee hearing held Thursday, Democrats and shareholder activists continued to call for increased disclosure and accountability, while Republicans, compensation consultants, and advocates for chief executives fought to curb proposals that would stifle the “free markets.”

Still, their tactics were similar. Each side slung statistics at the other to either prop up or dismantle the reasoning of H.R. 4291, the latest House bill on the subject. Called The Protection Against Executive Compensation Abuse Act, it would require the disclosure of more key compensation metrics and benchmarks, shareholder approval for corporate compensation policies, and repayment of incentive compensation if an executive is involved in fraud or misleading accounting.

Opponents of current management pay scales contend that compensation isn’t matching performance. Nell Minow, editor of The Corporate Library, a governance advocacy and advisory group, asserted that executive pay “must be looked at like any other allocation of corporate assets.” By her lights, recent return on investment for executive pay is not measuring up to any other use of corporate capital.

In testimony supporting the bill and the Securities and Exchange Commission’s proposal that corporations should be required to disclose more about executive pay in their financial statements, Christiania Wood, senior investment officer of the California Public Employees’ Retirement System, cited a 2005 study of 350 companies, which reported a boom in senior-management pay. Mercer reported that median salary and bonuses for chief executives rose by 7.1 percent to $2.4 million, following the previous year’s record compensation increase of 14.5 percent.

The rise in pay came amid reports of CEOs who were awarded bonuses while presiding over stock price slides or being ousted, said Wood. What troubles Calpers, she added, is not necessarily the increase in pay but whether raises are aligned with increases in shareholder value.

Ironically, Mercer’s study was also used in calculations by compensation consultant M. Frederic Cook, who contends that current criticisms of executive pay are overblown. He first pointed to media reports that claimed the pay ratio between an average large-company CEO and an average American worker is 430:1, but he said the finding is skewed, noting that the ratio includes realized option gains. Cook argued that those are a payoff from many years of grants and rising stock prices, not a single year’s pay package. Further, the ratio focuses on average rather than median CEO pay, so the total is inflated by a few highly paid chiefs.

A better way of calculating the CEO-worker ratio is to use Mercer’s survey and its median pay benchmark, contended Cook, noting that the survey breaks down pay packages into such components as salary and annual cash pay (salary plus bonus). For his calculations, Cook asked Mercer to use Black-Scholes option-grant values instead of the realized option gains the actuarial firm had used. Black-Scholes, he thinks, better reflects the intention of board compensation committees.

Further, Cook substituted the average annual earnings of the American worker with the median salary for individuals between ages 25 and 64 who worked full time for a full year. By the end of his calculation, the ratio gap closed to 187:1. He also found that the pay ratio peaked in 2001, during the tech bubble. “The fact that the CEO pay ratio has been trending below its peak level for four years running has not been reported in the press to our knowledge,” said Cook.

And while he supports provisions of the SEC’s proposal, Cook thinks the House bill is overkill: most of its strictures have already been addressed in the SEC proposal or in Section 304 of the Sarbanes-Oxley Act, which calls for CEOs and CFOs to forfeit bonuses and profits if there’s misconduct in their companies.

What would be more helpful, says Cook, is for the government to encourage good compensation practices by providing a tax break for incentive perks. That way, the concept of incentive-based pay would spread throughout the company, reasons Cook, narrowing the CEO pay gap “not by lowering the top, but raising the bottom.”

Calpers’s Wood disagrees: the current pay system contains too many conflicts of interest and isn’t driven by such operational incentives as productivity. She sees an inherent conflict of interest when CEOs receive bonuses for completing a merger, acquisition, or sell-off. In such cases, she contends, chief executives are driven by personal compensation goals, not what may be best for the company.