CEO pay: a new way to judge the numbers; A dive into three companies' pay and performance data provides a compelling guide for compensation committees trying to determine what level of pay is 'just right.'.

• Author: Burchman, Seymour
• Position: EXECUTIVE COMPENSATION

HOW MUCH PAY is "just right" for a CEO? Compensation committees struggle to answer this question, particularly at this time of year, when proxy statements open to the world the committee's decisions about executive pay. Although no single "right answer" exists, there are analytical approaches and contextual considerations that can offer greater comfort to committees.

CEO pay, particularly long-term incentives (LTI), has been rising at extraordinary rates since the early 1990s. LTI opportunities alone have increased by 350 percent. CEO total direct compensation (TDC) has moderated in recent years, perhaps in response to increased disclosure, shareholder activism, and the expensing of options. Yet levels remain high--so high that many boards, and even many CEOs, question whether payouts are reasonable.

While some perquisites and retirement benefits have been shaved back, causing subtle dips in total compensation, a significant across-the-board rollback of CEO pay is unlikely. A compensation committee taking such a step could put the company at a competitive disadvantage. But there are actions that compensation committees can take to ensure that the size of the opportunity and the program design are structured properly to align with performance and share value fairly among executives and shareholders. The price for success can--and, perhaps, should--be high. One could argue that those who create value deserve a significant payback. Lackluster results and, even more so, failure to perform should not produce a hefty payday, particularly when shareholders and other employees come up short.

How does a compensation committee avoid such discrepancy? And further, what factors should they consider in order to determine what level of pay is the right amount?

Seeking answers to four questions

We decided to look at the amount of pay a CEO earns and work backward to first assess how a CEO's paycheck measures up against performance delivered, and then to discover what aspects of plan design drive those outcomes. We focused on pharmaceutical and biotechnology companies because they typically represent some of the highest-paying industries for executive talent. From this group, we selected companies that spanned a broad spectrum from high to poor performance. Then, to keep things simple, we chose three representative companies across the performance spectrum for more in-depth analysis: Company A, a high performer; Company B, an average performer; and Company C, which has experienced several years of sub-par performance. (All three are Fortune 500 NYSE-traded companies.) For each of the companies, we examined five years (2001-2005) of publicly available total compensation data alongside the companies' performance levels to assess whether the amount of pay balanced with results achieved. (See sidebar on page 37 on our methodology.)

In practice, a more robust analysis would include a far larger number of companies (15 to 20), preferably in the same industry and of similar size. We also acknowledge that looking at the numbers alone tells only part of the story. Other factors, such as pipeline strength, patent expirations on blockbuster drugs, and competitor's product offerings, have an impact on performance. But the focus of this analysis is on the numbers that are "out there" for public consumption and that contribute to public dismay. Even from this simple review, interesting insights emerge.

Our analysis sought answers to four important questions that compensation committees should be asking when evaluating CEO pay:

1. Does CEO pay align with company performance?

2. Is the value delivered to the CEO commensurate with the level of value delivered to shareholders?

3. What are the potential...