MYTHS AND REALITIES OF EXECUTIVE PAY -...

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MYTHS AND REALITIES OF EXECUTIVE PAY The executive pay model used widely in the United States is essential both to the continued success of companies and to the U.S. economy itself. The suc- cessful application of this model, which is built on the foundation of pay-for- performance, has helped create an economic juggernaut, resulting in trillions of dollars of wealth for shareholders and substantial income and net worth for millions of corporate employees and their families. High executive pay simply reflects the strong demand for top talent and can be evaluated with consideration of the performance that leads to high pay. Yet, myths of a failed model still abound, perpetuated by occasional excesses, recent corporate scandals, and controversy over the use of stock options. This book documents the realities of executive com- pensation by investigating the extent to which the pay-for-performance model governs executive pay levels. It also assesses the relative success of this model in creating value for shareholders and robust job growth for U.S. employees and provides detailed, real-world guidance for designing and executing effective exec- utive compensation plans. Based on extensive empirical research and decades of direct experience in the field, Myths and Realities of Executive Pay settles the debate about executive compensation and the role it plays in the broader U.S. economy. Ira T. Kay, Ph.D., global practice director of executive compensation consulting at Watson Wyatt Worldwide, headquartered in Washington, DC, is a nationally recognized expert on executive compensation. He has helped U.S. public, pri- vate, and international companies develop annual and long-term incentive plans to increase shareholder value. Dr. Kay has written and spoken extensively on executive compensation issues and conducted research on executive pay, stock ownership, and stock options. He is coauthor of the book The Human Capital Edge and is the author of CEO Pay and Shareholder Value: Helping the U.S. Win the Global Economic War and Value at the Top: Solutions to the Executive Com- pensation Crisis. Dr. Kay has published articles in the Harvard Business Review, McKinsey Quarterly, Journal of Deferred Compensation, and Across the Board. He has also presented analysis of executive compensation issues before the Federal Reserve Board, the Securities and Exchange Commission, the Financial Account- ing Standards Board, and a U.S. Senate subcommittee. He is frequently quoted in the major business press and speaks globally on executive compensation issues. Steven Van Putten is the East region practice leader of Watson Wyatt’s executive compensation consulting practice. He focuses primarily on advising compensa- tion committees and senior management on executive and director compensa- tion matters. Mr. Van Putten has spoken and written on executive and incentive compensation and specializes in the design and development of annual and long- term incentive programs that drive business strategy and support organizational objectives. He is also an expert on FAS 123(R) and its implications for stock-based incentives. © Cambridge University Press www.cambridge.org Cambridge University Press 978-0-521-87195-2 - Myths and Realities of Executive Pay Ira T. Kay and Steven Van Putten Frontmatter More information

Transcript of MYTHS AND REALITIES OF EXECUTIVE PAY -...

MYTHS AND REALITIES OF EXECUTIVE PAY

The executive pay model used widely in the United States is essential both tothe continued success of companies and to the U.S. economy itself. The suc-cessful application of this model, which is built on the foundation of pay-for-performance, has helped create an economic juggernaut, resulting in trillionsof dollars of wealth for shareholders and substantial income and net worth formillions of corporate employees and their families. High executive pay simplyreflects the strong demand for top talent and can be evaluated with considerationof the performance that leads to high pay. Yet, myths of a failed model still abound,perpetuated by occasional excesses, recent corporate scandals, and controversyover the use of stock options. This book documents the realities of executive com-pensation by investigating the extent to which the pay-for-performance modelgoverns executive pay levels. It also assesses the relative success of this modelin creating value for shareholders and robust job growth for U.S. employees andprovides detailed, real-world guidance for designing and executing effective exec-utive compensation plans. Based on extensive empirical research and decades ofdirect experience in the field, Myths and Realities of Executive Pay settles thedebate about executive compensation and the role it plays in the broader U.S.economy.

Ira T. Kay, Ph.D., global practice director of executive compensation consultingat Watson Wyatt Worldwide, headquartered in Washington, DC, is a nationallyrecognized expert on executive compensation. He has helped U.S. public, pri-vate, and international companies develop annual and long-term incentive plansto increase shareholder value. Dr. Kay has written and spoken extensively onexecutive compensation issues and conducted research on executive pay, stockownership, and stock options. He is coauthor of the book The Human CapitalEdge and is the author of CEO Pay and Shareholder Value: Helping the U.S. Winthe Global Economic War and Value at the Top: Solutions to the Executive Com-pensation Crisis. Dr. Kay has published articles in the Harvard Business Review,McKinsey Quarterly, Journal of Deferred Compensation, and Across the Board. Hehas also presented analysis of executive compensation issues before the FederalReserve Board, the Securities and Exchange Commission, the Financial Account-ing Standards Board, and a U.S. Senate subcommittee. He is frequently quoted inthe major business press and speaks globally on executive compensation issues.

Steven Van Putten is the East region practice leader of Watson Wyatt’s executivecompensation consulting practice. He focuses primarily on advising compensa-tion committees and senior management on executive and director compensa-tion matters. Mr. Van Putten has spoken and written on executive and incentivecompensation and specializes in the design and development of annual and long-term incentive programs that drive business strategy and support organizationalobjectives. He is also an expert on FAS 123(R) and its implications for stock-basedincentives.

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MYTHS AND REALITIES OFEXECUTIVE PAY

Ira T. Kay, Ph.D.Watson Wyatt Worldwide

Steven Van PuttenWatson Wyatt Worldwide

© Cambridge University Press www.cambridge.org

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CAMBRIDGE UNIVERSITY PRESS

Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, Sao Paulo, Delhi

Cambridge University Press32 Avenue of the Americas, New York, NY 10013-2473, USA

www.cambridge.orgInformation on this title: www.cambridge.org/9780521871952

C© Watson Wyatt Worldwide 2007

This publication is in copyright. Subject to statutory exceptionand to the provisions of relevant collective licensing agreements,no reproduction of any part may take place withoutthe written permission of Cambridge University Press.

First published 2007

Printed in the United States of America

A catalog record for this publication is available from the British Library.

Library of Congress Cataloging in Publication Data

Kay, Ira T.Myths and realities of executive pay / Ira T. Kay, Steven Van Putten.

p. cm.Includes bibliographical references and index.ISBN 978-0-521-87195-2 (hardback)1. Chief executive officers – Salaries, etc. – United States. 2. Executive ability –United States. 3. Competition, International. I. Van Putten, Steven. II. Title.HD4965.5.U6K389 2007331.2′8165800973–dc22 2007000721

ISBN 978-0-521-87195-2 hardback

Cambridge University Press has no responsibility forthe persistence or accuracy of URLs for external orthird-party Internet Web sites referred to in this publicationand does not guarantee that any content on suchWeb sites is, or will remain, accurate or appropriate.

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Contents

Acknowledgments page xiPrologue: The Compensation Committee Meets xiii

Introduction: The Battle over Executive Compensation . . . . . . . . . . . . . 1

Executive Compensation in the U.S. Corporate Model 3The Goals of Executive Compensation 4Our Approach 6

Our Views, 6

1 The Myths and Realities of Pay-for-Performance . . . . . . . . . . . . . . . . . 8

The Realities of Pay-for-Performance 9Other Issues 22Case Studies of Pay-for-Performance 23

2 Managerial Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Academic Response to Bebchuk and Fried 30The Realities of Managerial Power 33Camouflaged Compensation 35At-the-Money Strike Prices 36Repricings and Reloads 38Diversifying, Hedging, and Timing 38Peer Group Data and Upward Bias 39Other Factors in Setting Pay 40Fixed Shares versus Constant-Dollar Techniques 42Conflicts of Interest 44Conclusion 45

3 External Pressures: The New Context for Executive Compensation . . . . 47

Characteristics of External Forces 47Cyclical Reforms and Unintended Consequences 49

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vi Contents

The Genesis of the Current Environment 50The Regulators 52

Securities and Exchange Commission, 52 � FinancialAccounting Standards Board, 54 � Internal RevenueService, 54 � NYSE and NASDAQ, 55 � Congress, 57

The Reformers 58Institutional Investor Perspectives, 60

Concerns with Lack of Pay-for-Performance 60Stock Incentives, 61 � Performance Metrics, 62 � Severanceand Change-in-Control Agreements, 62

The Financial Activists 64LBO Impact 64

Impact of Change-in-Control Protection, 66 � HedgeFunds, 67

Media Critics and Public Figures 68What We Can Learn 69

4 End of an Era: The Decline of the Stock Option . . . . . . . . . . . . . . . . . . 71

The 1990s: The Decade of the Stock Option 722000–2002: A Turning Point 75The Decline of the Stock Option 76The Realities of Expensing 77Perceived Value 79The Case for Stock Options 81

Growth Companies, 82 � Situational Cases, 82

Costs and Stock Prices 83Reducing the Expense 85

5 The Future of Long-Term Incentives . . . . . . . . . . . . . . . . . . . . . . . . . 87

Factors Influencing LTI Design 89Designing an LTI Program 89

Setting Performance Goals and Metrics, 95

Basis for Measurement 98Internal Goals, 99 � External Goals/Indexing, 99 � HybridGoals, 100

Goal Setting 101Determining Share Award Sizes 103A Look to the Future 105

6 Executive Stock Ownership: The Solution to the ExecutiveCompensation Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

Agency Theory and Costs 107

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Contents vii

Moral Hazard 109Driving Superior Returns 110

Stock Incentive Levels and Structures Are inTransition, 114

Stock Ownership Guidelines 114Stock Holding Requirements 115Net Share Retention Requirements 116Other Mechanisms for Creating Ownership 118Management Stock Purchase Plans 119

Tax Implications, 120 � FAS 123(R), 121

Finding the Right Solutions 121

7 Director Compensation in the New Environment . . . . . . . . . . . . . . . . 123

The Evolution of Director Compensation 125Move Away from Stock Options 126Activity-Based Compensation 128Compensating Committee Chairs and Members 128General Electric as a Reference Point 130Director Compensation Levels and Mix 131Director Share Ownership 132Stock Ownership Guidelines 133Net Share Holding Requirements 134Ownership Effectiveness 135Structuring the Optimal Director Compensation Package 137The Future of Director Compensation 139

8 The Compensation Committee: Creating a Balance betweenShareholders and Executives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Legal Context 142Right from Wrong? 144

Are Stock Options Performance-Based? 144 � ArePerformance Shares the Perfect Solution? 145 � ShouldDirectors Be Required to Own Company Stock? 145 �

Should Peer Groups Be Used to Set Executive Pay? 145 �

What Constitutes a Good Board Member? 145

Foundations for Best Practices 146Creating Excellence in Corporate Governance 147Institutional and Regulatory Governance Recommendations

and Mandates 148Consultant Independence 150Setting the CEO’s Pay as Rigorously as Possible 151Case Study of an Internal Promotion 152Creating a Pay-for-Performance Environment 154

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viii Contents

Rule 10b5–1 Plans – Preannounced Purchases or Sales ofStock 159

Best Governance Practices in Designing Annual andLong-Term Incentives 161

9 Aligning All Employee Pay to Improve Corporate Performance . . . . . . 162

Elements of Alignment 163Aligning Architecture and Performance Measures, 163

Untenable Forms of Alignment 164Performance-Pay Solutions 165

Merit Increases, 167 � Short-Term Incentives, 168 �

Stock-Based Incentives, 169

Employee Stock Ownership 169The Role of Stock Options 170Moving Beyond Options 172Converting to Restricted Stock 174Adjusting Stock-Based Incentives 176Alignment in Practice 177Building Better Alignment 178

10 International Executive Pay Comparisons . . . . . . . . . . . . . . . . . . . . 180

U.S. Competitive Advantage 181The International Executive Pay Gap 183United Kingdom 185France 189Canada 192Asia 194

Japan, 197 � Singapore, 197 � China, 197 � Hong Kong,199

Summary 202

Conclusion: The Future of Executive Compensation . . . . . . . . . . . . . . 204

Epilogue: Back in the Boardroom . . . . . . . . . . . . . . . . . . . . . . . . . . 209

Appendix A.Legal and Regulatory Requirements for ExecutiveCompensation Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

Nonqualified Stock Options 215Incentive Stock Options 218Stock Appreciation Rights 219Restricted Stock Units 222Restricted Stock 226

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Contents ix

Appendix B.Summary of the Regulatory and Institutional Mandatesand Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229

CalPERS 229TIAA–CREF 230Fidelity 231Vanguard 232Union-Sponsored Funds 232Other Organizations 234

The Council of Institutional Investors, 234 � InstitutionalShareholder Services, 236 � Glass, Lewis & Company, 238� National Association of Corporate Directors, 239 � TheConference Board, 240

Appendix C.Academic Articles on Pay-for-Performance and theEffectiveness of the Executive Labor Market . . . . . . . . . . . . . . . . . . 243

Notes 247Index 253

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Acknowledgments

The myths of ever-rising executive pay, unchecked management power,and a failed pay-for-performance model, perpetuated by the media, havereached a visceral crescendo. We have reached a critical juncture in thefuture of executive pay. We present a different and successful reality ofexecutive pay comprising pay-for-performance, an efficient labor mar-ket, and an effective corporate governance model. This reality is basedon extensive primary and secondary research combined with dozens ofyears of experience consulting to successful corporations. In our effortto separate fact from fiction and thus dispel the myths surroundingexecutive compensation, we are greatly indebted to our colleagues andclients, who have allowed us to test many of our hypotheses in real-worldsituations.

Our colleagues at Watson Wyatt Worldwide contributed greatly, bothdirectly and indirectly, to the contents of this book. In particular, wewould like to thank Steve Seelig for his contributions to Appendixes Aand B, Chris Hamilton for his contributions to Chapter 8, and MichaelMarino for his contributions to Chapter 5. We also greatly appreciatethe contributions of our international colleagues who contributed signifi-cantly to Chapter 10 on international executive pay, specifically StephaneLebeau from Canada, Dominique Paris from France, Hans Kothius fromthe Asia-Pacific region, and John Ball from the United Kingdom.

This book would not have been written without the efforts of FayHansen, who was able to seamlessly mesh our styles and viewpoints.We also thank Dave Simmons, Richard Luss, Bob McKee, David Popper,Dana Finkelstein, Emily Rieger, Jacqueline Coles, and Renee Mailhoit,who were instrumental in helping us get this book ready for publication.

We also extend our appreciation to the critics of executive pay, includ-ing Lucian Bebchuk, Jesse Fried, Bud Crystal, and others who conduct

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xii Acknowledgments

important research that elevates the debate on executive pay. We hopethat this book serves to further a constructive dialogue on the importantissues of executive pay and performance.

Steven Van Putten would also like to acknowledge Paul Platten andBruce Hanson, both of whom were critical to his development as anexecutive pay consultant during the formative years of his career.

Finally, and most importantly, we thank our wives and children fortheir constant support and understanding: Carol, Sarah, Ben, Jon, Sam,William, and Jacob Kay; and Carolyn, Luke, Kelley Rose, and Sarah VanPutten.

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PROLOGUE

The Compensation Committee Meets

May 23, 2006

The chair of the compensation committee scans next week’s committeemeeting agenda. The first several items are perfunctory – approval ofminutes from the prior meeting, new-hire and promotional stock optionawards, and an update on a succession-planning project. No surprisesthere. But the last two agenda items leap off the page: status of employeestock purchase plan (ESPP) and broad-based option awards, and CEOemployment agreement renewal.

These are not unexpected. Several months ago, one of the outsidedirectors called the chair to discuss the ESPP and broad-based optionawards, raising a concern that the company was not getting much bangfor its buck; that it was incurring significant expense and dilution forthese stock-based awards that appeared to have little perceived valueamong employees.

In effect, the outside director was asking the committee to revisit thepreceding year’s decision to continue providing broad-based stock optionawards and an ESPP – a decision that was agreed to by both manage-ment and the committee. That stay-the-course decision had been madein the face of mandatory stock option and ESPP expensing that wouldgo into effect in January 2006. At the time, the decision made sense. Thecompany’s stock was trading near an all-time high, employee moralewas strong, and the company was having little difficulty attracting andretaining top talent. With the company’s broad-based equity programsapparently a key contributor to its success, the committee and seniormanagement were disinclined to make any rash changes.

But during the year, events had occurred that, in retrospect, calledinto question the appropriateness of the strategy. The company’s stock

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xiv Prologue

price had languished as a result of macroeconomic factors that adverselyaffected the company’s industry. The fact that the company’s flat stockprice reflected better performance than that of its peers offered littlesolace to employees whose stock options were now just treading water.

The situation for option holders was compounded by the company’sdecision to institute a fairly healthy dividend, which gave shareholdersa tax-effective return but provided option holders with no extra value.In addition, at the board of directors’ annual off-site meeting, the CEOhad described a short-term strategy that would necessitate several capitalinvestments, the benefits of which would likely not be reflected in thestock price in the near term.

At the same time, through its outside compensation consultant, thecommittee learned that the competitive landscape was indeed chang-ing. In a recent presentation to the committee, the consultant had notedthat many peer companies had begun to deemphasize stock options byintroducing alternative programs for senior levels of management and byreducing participation and/or shifting to vehicles offering a greater lineof sight between actions and rewards at lower employee levels.

The chair understands that these factors merit a reappraisal. But sheis concerned that dramatic changes could subvert several key objectives:fostering a culture of share ownership, promoting long-term retentionand perspective, and maintaining alignment with shareholders. She alsoworries that a transition away from stock options to full-value sharescould negatively affect the company’s emphasis on pay-for-performance.

On top of that, and even more visible, is the ironic juxtaposition withthe last agenda item – the renewal of the CEO’s employment agreement.

Three years ago, to lure the CEO to the then-underperforming com-pany, the board of directors had constructed an impressive pay package.In addition to competitive cash and equity compensation arrangements,the three-year employment agreement provided a large sign-on restricted-stock award, credited years of service under the company’s supplementalexecutive retirement plan (SERP), and provided a severance benefit equalto three times the combined base salary and annual bonus.

In the event the CEO was let go in connection with a change in controland his severance and related benefits constituted an excess parachutepayment (as defined under sections 4999 and 280G of the Internal Rev-enue Code), he would be entitled to a gross-up payment to reimburse himfor any excise taxes incurred. After reviewing detailed peer practices, thecompensation committee was comfortable that the package was appro-priately competitive.

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Prologue xv

Three years later, the board thinks the CEO has earned every pennyof his compensation package and that shareholders, in turn, have earnedan above-market return on their investment in the new CEO. The CEO’sunrelenting focus on controlling costs and realizing growth through newdistribution channels has spurred the company to its best performanceon record, despite a recently sluggish stock price.

Not surprisingly, rumors have been circulating that several companiesin need of a well-regarded turnaround expert have placed this CEO at thetop of their lists. For his part, the CEO enjoys working for the company,and he and his family want to stay in the area. He has communicated hiswish to remain with the company and is interested in entering into a newagreement that would secure his services for the duration of his career.The board wants the same thing, but external pressures are constrictingits ability to craft a new, attractive employment deal.

First, the company was recently sued by two separate shareholderswho claim that the CEO received excessive compensation. The chairknows that the lawsuit is frivolous and thinks it stemmed from the com-mittee’s efforts to improve the transparency of executive compensationdisclosure a year before being required to do so by the Securities andExchange Commission. In the company’s recently filed proxy statement,the compensation committee included a table showing the CEO’s totalremuneration, including the annualized value of benefits and perquisites.Because the CEO was a mid-career hire, the annualized SERP value,including the credited years of service, was an eye-popping number. Thelawsuit specifically notes the elements of compensation, including theSERP and the sign-on restricted-stock award, that are not directly relatedto performance.

To compound matters, in the same proxy statement, two large insti-tutional shareholders submitted separate executive pay resolutions, thefirst to limit severance benefits to no more than one times the combinedsalary and bonus and the second to require shareholder approval of theSERP. While the chair knows that these proposals are nonbinding, sheis sensitive to the scrutiny the company will receive if they pass and thecompany subsequently files a Form 8-K disclosing the terms of a newCEO employment agreement.

It is apparent to the chair that there are multiple stakeholder per-spectives on these issues and that most are in conflict. Therefore, she hasasked that the final two agenda items be structured as review and dis-cussion items rather than approval items. She has also asked the head ofhuman resources to survey a cross section of employees about the current

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xvi Prologue

equity programs compared with other forms of remuneration. And shehas asked the compensation consultant to collect and interpret data onpeer practices.

A week before the meeting, the chair and the committee membersreceive the requested materials and the agenda. The challenge for thechair will be to channel the discussion toward achieving an outcome thatbenefits all stakeholders and, at the same time, reflects good corporategovernance practices that will withstand public scrutiny.

May 30, 2006

At the meeting, the chair quickly dispenses with the initial items on theagenda. Diving right into the item on the employee stock option awardsand ESPP, she asks the senior vice president of human resources to dis-cuss the results of the employee survey. The SVP notes several pervasivethemes: that the ESPP is viewed as an attractive benefit and that mostemployees value options for the recognition – and the affinity to the com-pany – they provide. Like shares acquired through the ESPP, options aregenerally cashed in as soon as they vest.

One finding from the survey that concerns, but does not surprise, theSVP is the wide disparity in views based on demographics and employeelevel. Older employees in general prefer the security of restricted stockor cash to the upside potential of options more than younger employeesdo. However, the more senior the position, the greater the value the indi-vidual places on stock options. The SVP is concerned that changes to thecurrent programs could create internal strife.

The compensation consultant then provides an overview of thechanging competitive landscape. An increasing number of peer com-panies are shifting away from stock options, as evidenced by decliningannual share usage rates and award sizes. At the executive level, compa-nies are making up for reduced option award levels by introducing long-term performance plans, denominated in cash or shares. Although lessclear from publicly disclosed data, it appears that companies are limitingstock option award eligibility for lower-level employees and that severalare shifting to restricted stock with award levels that are differentiatedon the basis of individual performance.

The chair asks the consultant to work with the SVP and his team todevelop alternative approaches and evaluate long-term incentives (LTIs).She says that the committee expects a specific recommendation withsupporting LTI rationale.

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Prologue xvii

At this point, the chair excuses senior management, and the commit-tee goes into executive session to discuss the CEO’s employment agree-ment. She tells the committee members that the CEO has said he is look-ing for more security that will in effect lock him in with the companyfor the rest of his career. He has mentioned the possibility of an addi-tional restricted-stock award and an enhancement to his supplementalretirement benefit.

One of the committee members objects, saying that maintaining linksto performance is the key objective and that the prior restricted-stock andSERP credits were used as part of an employment inducement strategy.

The chair asks the consultant to develop alternative approaches andto work with her directly on the issue. With the meeting adjourned, sheturns to the consultant and asks how executive compensation became socomplicated so fast. “It’s an interesting story,” he says, “and the mythsoften overshadow the realities.”

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