Rethinking today's CEO pay practices.

• Author: Kontes, Peter
• Position: Executive Compensation

Following these suggested guidelines, boards will be able to establish compensation plans that are simpler, better aligned with the capital and labor markets, and likely to be perceived as more equitable.

FEW ELEMENTS OF corporate governance have received more negative publicity or calls for reform in recent years than executive compensation, especially CEO compensation. Among the leading schools of thought on the subject are social engineers (pay is too high in relation to that of ordinary employees), financial engineers (pay is not linked effectively to economic performance), and legal engineers (the process of setting CEO pay is not sufficiently objective or independent). We have limited comment on the social engineering perspective, but there is much to consider in the financial and legal engineering positions.

In practical terms, most suggested reforms have focused on stock option programs, with the general view being that whatever good intentions boards have had in granting stock options, the actual results have ranged from compensation levels that seem arbitrary at best to iniquitous at worst. There has been less commentary about reforming the overall structure of executive compensation packages, including base salary and short- and longterm cash compensation as well as stock options and other awards. We believe effective reform will require this more comprehensive perspective.

Typical package

Briefly, the typical CEO pay package in a large U.S. public company today looks something like this:

* Annual base salary: usually around $1 million paid in cash.

* Short-term incentive bonus: usually ranges from 50% to 200% of annual base salary, paid in cash, for achieving annual or "short-term" objectives -- most commonly, an earnings or EPS target is the major driver of this component.

* Long-term incentive bonus: size, forms, and timing of payments vary widely, with stock option grants usually being a significant component -- often as high as 60% to 70% of total compensation prior to the recent bear market.

The details may vary widely, but the overall compensation structure is remarkably similar across companies, with relatively low "fixed" and high "variable" pay for CEOs. While this may seem sensible in theory, in practice the results have often been disappointing. Most notably, many companies with unexceptional performance have nevertheless paid their CEOs tens or even hundreds of millions of dollars in bonuses over the past several years, primarily through the use of ordinary stock options. Shareholders are rightly outraged, and boards have sometimes been clumsy and unconvincing in explaining why they allow this to happen.

An alternative approach

What is being proposed here is to turn this conventional structure around: Pay much higher annual base salaries but have much more selective payment of bonuses, with only truly exceptional company performance driving exceptional CEO pay. Two important observations underpin this proposal: Current practices are not well aligned with CEO labor market requirements; they are also poorly aligned with capital market requirements.

With respect to the CEO labor markets, the annual base salary levels for CEOs appear...