Executive pay and its critics.

• Author: LOCHNER JR., PHILIP R.

Here are some smart steps a board and a CEO can take to help avoid feeling the heat on the pay issue.

EVERY YEAR, as predictably as death and taxes, yet another example of "obscene" executive pay is spread across the pages of The Wall Street Journal, Business Week, Fortune and Forbes, not to mention the New York Times and the Washington Post. Words like "greed," "unconscionable," and "outrageous" are thrown around. Boards are chastised for permitting excessive executive compensation to be paid, and shareholder activists fume.

And just as predictably, every year the executive who is the unhappy beneficiary of all this unwanted publicity, the company for which he or she works, and often its board, spend months trying to calm the choppy waters and explain why what seems to be an enormous amount of money is really well deserved. Usually the damage to all concerned from this sort of attention is not long lasting. But the experience is nonetheless painful.

Why do good companies, executives, and boards end up in these situations? How can they be avoided? There is no easy formula for managing the executive pay issue. But understanding some of its roots and current manifestations may help.

The key elements of executive pay have not changed much in the past half century. They remain base salary, annual bonus, stock options, and benefits. But while base pay was the largest component of executive compensation 50 years ago, it has now been supplanted by stock-based pay, followed by the annual bonus, with benefits falling into last place. This change in executive compensation -- the ever-increasing emphasis on stock-based pay -- has had significant consequences, which I explore below. The other most significant change in executive compensation over the last five decades is that CEO pay has, of course, been increasing substantially, particularly in the last 20 years.

There are many causes for this increase in executive pay, and the explosive growth of equity prices over the last decade is only one cause. Another is the desire of every board to pay at the top level, to attract and retain the best people. Yet another cause has undoubtedly been fuller disclosure of pay in proxy statements, which has made all pay more visible. I have heard board members say, referring to a CEO at another company, "Well, if he's getting x, then our guy should get at least the same." Thus, oddly, proxy disclosure has driven pay up, when the motive for the disclosure was at least partly to keep it in check.

The booming economy has also drive pay up; talent is scarce and there are plenty of opportunities for talented executives to jump ship for higher offers elsewhere. And overall corporate earnings have gone up substantially over the last decade as well.

Whatever the causes for high CEO pay, it is clear that a reaction is setting in. There are three principal criticisms heard these days about executive pay.

Just too much

The first is a general criticism, and goes to the overall level of total CEO pay. The criticism is that no matter how well the shareholders are doing, CEOs are just getting too much money. Pay levels are called "obscene." This is not an intellectually serious criticism; it is an esthetic criticism. Obscenity is in the eye of the beholder. I think the federal budget is obscene, but you may think it is the Renoir of finance.

A second criticism starts out by comparing average CEO pay and the pay of the average worker on the assembly line. The AFL-CIO reports that the average production worker last year earned about $30,000, while the average...