CEO Pay: The New Rules

For CEOs and other senior executives in manufacturing, performance-related bonuses are up, stock options are less popular and per-formance-tied long-term incentives are more common. But will they make for better management decisions? That's not yet clear.

Think CEO. Think a humongous salary that's growing beyond belief. Think an ever-bigger bonus that seems unrelated to value creation or anything else. Think lots and lots and lots of stock options.

Think again. Chief executive pay is increasingly being tied to performance

The performance-rewarding bonus that a typical CEO of an IndustryWeek 50 Best Manufacturing Company -- one of the 50 U.S. manufacturers with the best profits and asset utilization -- received last year was $1.41 million, 24.7% higher than the 2003 bonus of $1.13 million. But the higher bonus, which was in addition to a base salary of $834,000, closely tracked the company's 20% increase in total shareholder return, reveal data compiled by DolmatConnell and Partners Inc., the Newton, Mass.-based compensation and benefits consulting practice of The Odyssey Companies. At the same time, the $5.46 million in long-term incentives the CEO received was 52.2% higher than the $3.59 million dispensed in 2003. However, the mix was shifting toward rewarding performance, the DolmatConnell data show, with the CEO receiving 50% more in restricted stock than in 2003, 23% more in other performance-based incentives, and just 7% more in stock options,which tend primarily to aid executive recruiting and retention.

These changes in compensation among the IW 50 companies -- the closer relationship between pay and performance -- are complemented by the results of this year's survey of CEO compensation among the 350 largest U.S. firms, including manufacturers, done by Mercer Human Resource Consulting for The Wall Street Journal. Its data show the median CEO salary last year was $975,000, up just 3.7% from 2003. The $1.5 million median annual CEO bonus in 2004 was 20% higher than the 2003 bonus, but the increase was consistent with a 23% rise in company net income. The percentage of stock options was lower last year, and CEOs got higher percentages of long-term incentives that required them to stick around the company for more than 10 minutes and to meet or beat performance goals.

Manufacturing Shifts To Performance
CEO compensation and company performance at IW 50 companies

Base salary

2004 $834,000
2003 $775,000
Change +7.6%

Bonus

2004 $1,410,000
2003 $1,131,000
Change +24.7%

Long-term incentives

2004 $5,461,000
2003 $3,589,000
Change +52.2%

Company Financial Results

Revenue growth

2004 +14%
2003 +13%

Net income growth

2004 +17%
2003 +19%

Total shareholder return

2004 +20%
2003 $3,589,000
Source: DolmatConnell and Partners Inc.
Like it or not, CEOs and other senior executives in manufacturing are in office at a time when, for a variety of reasons, boards of directors and investors are insisting on stronger demonstrated connections between executive pay and a firm's performance. And they're in pretty good company. With Jeffrey R. Immelt, chairman and CEO of General Electric Co., for example. Beginning in September 2003, GE's board tied the equity part of Immelt's compensation to the company's cash-generation performance and to total shareholder return meeting or beating the S&P 500. And at the same time, grants to key employees below the senior executive level, previously 100% stock options, became a combination of 60% stock options and 40% restricted stock.

"We are clearly seeing a shift away from stock options to other long-term-incentive approaches in the manufacturing industry," says Southfield, Mich.-based Dominic Andwan, an executive and incentive compensation consultant at Watson Wyatt Worldwide. For example, among manufacturers the use of stock options as an executive incentive will be down to 60% to 70% of companies in 2006 and beyond, still fairly widespread but significantly lower than the 80% to 90% of manufacturers that used stock options in 2003, Andwan forecasts. Simultaneously, the use of such long-term and often more closely related performance incentives as restricted stock will rise to 60% to 70% of manufacturers in 2006 and after, roughly double the 30% to 40% of manufacturers using them in 2003, he predicts.

Out With Options

Drill down into Mercer's data, and the pay-for-performance connection becomes even clearer. For example, from 2001 through 2004, while salary rose to 19% from 16% as a percentage of total CEO compensation, the annual bonus, which can be used to reward short-term performance, nearly doubled to 25% from 13% as a portion of total compensation. And although long-term incentives fell to 56% from 71% as a percentage of total compensation, consider that the decline was largely accounted for by fewer grants of stock options. Driven by shareholder concerns about further diluting shares and the prospect of new rules requiring they be accounted for in the year of issue, stock options declined to 57% of the total value of long-term incentives in 2004 from 76% in 2002. During the same period, restricted stock rose to 22% from 12% of total value, and long-term performance shares increased to 20% from 12%. The Mercer survey of the 350 largest publicly traded U.S. companies shows the number of CEOs receiving stock options slid from 295 in 2002 to 278 in 2003 to 273 in 2004. Meanwhile, the number of CEOs receiving some sort of restricted incentive, which typically vests over three or four years or is tied to achieving one or more performance figures, rose from 104 in 2002 to 138 in 2003 to 166 in 2004.

With "nearly every manufacturing company I work with, the board or management has asked us to review the portfolio of long-term incentives awarded senior executives to make recommendations as to the approach that will maximize the return to the company for the cost incurred by the company," says Watson Wyatt's Andwan. "Our research consistently shows that if executives have higher levels of actual stock ownership in the company . . . you're going to see higher levels of total shareholder return." That should make restricted stock and performance shares, which an executive actually owns, relatively more attractive than stock options, which Andwan says 95% of executives historically have cashed-out once the options have been exercised. "Most board members have come to the realization that nobody washes a rented car," he quips.

CEO Compensation By Business Sectors
% change from 2003
Sector Salary & Bonus
(S&B)
Total Direct Comp
(TDC)
S&B TDC Company
Basic materials $2,200,000 $5,529,600 58.2% 21.7% 64.8%
Consumer goods $3,425,000 $9,575,500 25.0% 33.1% 18.8%
Consumer services $1,698,100 $5,075,200 8.7% 1.7% 10.2%
Financial $3,129,600 $8,471,400 5.2% 2.2% 17.6%
Health Care $2,202,500 $10,343,600 4.8% 7.4% 13.7%
Industrials $2,183,300 $5,766,600 24.9% 28.6% 40.8%
Oil & Gas $3,900,000 $10,594,600 15.3% 29.9% 78.0%
Technology $2,181,900 $8,766,000 11.5% 15.2% 82.1%
Telecommunications $3,228,900 $16,382,500 0.5% -3.6% 0.3%
Utilities $1,899,000 $4,984,400 8.1% 10.4% 16.4%
Source: Mercer Human resource Consulting. Sample is the 350 largest U.S. publicly traded firms. Total direct compensation includes base salary, annual bonus and long-term incentive grant values (including the binomial value of stock options, restricted stock and other long-term initiatives)

More important than the issue of stock options versus holding stock, however, is "the fact that we can start to build in performance measurements that need to be attained before the option can be exercised or before the risk provisions go away on a restricted stock," contends John M. Wirtshafter, an attorney in the employee benefits practice at Cleveland-based McDonald Hopkins Co. LPA, a business law firm. Those performance goals can be generic, such as the company's stock exceeding some figure or they can be tailored to what's relevant for a specific employee in a specific part of the company, such as tying the awards of a vice president of sales to revenue, margins or new accounts, he explains.

At the chief executive level, long-term incentives, particularly restricted shares with their vesting period, also tend to keep well-performing CEOs where they are and make it more difficult for other companies to lure them away, adds Adam P. Kohn, vice chairman of Christian & Timbers, an executive search firm based in Cleveland. Indeed, for a company trying to recruit an outstanding CEO from outside the firm, coming up with the cash is not the issue. "The cash, most of the time they can match or exceed," says Kohn. "It's the long-term incentive plans that are really difficult and challenging for some of these mid-tier manufacturing companies to match to attract these people."

Change Management

Incremental change is happening. Thirty years ago, the CEO of a major U.S.-based multinational observed that while he and other senior manufacturing executives talked about the long term, they were still being paid for the short term. There's still plenty of executive pay for short-term performance. CEOs -- and boards, for that matter -- expect to start seeing the returns on such innovations as lean production practices almost immediately and not four or more years into the future. For boards, a major challenge -- and one that all are not yet up to -- is to find a an executive compensation mix that works for the short term and long term and that makes sense for the company and its industry. "If you are in a mature manufacturing environment, where you are not expecting the same type of growth, or if you are going to go through a turnaround situation or something like that, you are going to see companies more often balancing that portfolio on the retention side of things for the executive population. You will see more restricted stock and performance shares," says Watson Wyatt's Andwan. "However, if your manufacturing company continues to have high growth prospects and will still maintain strong earnings that will support a higher valuation in the marketplace, stock options continue to be an efficient and effective [long-term incentive]," he states.

Compensation's Ups & Downs
10-year trend for CEOs and exempt employees (% change)
Year CEO Compensation
(Salary & Bonus)
Exempt employees'
compensation
Corporate Profits CPI
1995 10.4% 4.2% 14.2% 2.8%
1996 5.2% 4.0% 11.0% 3.0%
1997 11.7% 4.2% 8.9% 2.3%
1998 5.2% 4.2% 5.0% 1.6%
1999 11.0% 4.2% 15.1% 2.2%
2000 10.0% 4.2% 8.9% 3.4%
2001 -2.8% 4.4% -17.8% 2.8%
2002 10.0% 3.8% 14.8% 1.6%
2003 7.2% 3.6% 19.2% 2.3%
2004 14.5% 3.4% 23.0% 2.7%
Source: Mercer Human resource Consulting. Sample is the 350 largest U.S. publicly traded firms. Percent change is from the previous year. CPI is the U.S. Labor Department's Consumer Price Index.


But, as you might ask about those exercise machines advertised on television that promise to produce killer abs, do performance-tied incentives really work? Do such long-term incentives as stock options, restricted stock and performance shares actually produce better executive decisions on such things as outsourcing, R&D, capital investment, and employee training and development? "It may be a little premature to make that judgment at this point in time," says McDonald Hopkins' Wirtshafter. "But, anecdotally it seems like it works, and it seems to make more sense," he says. "The one thing that is clearly true is that executives and employees are not dumb people. They figure out what they need to do to get their compensation."

Maybe. Management and compensation have a more complicated relationship.

A huge difference, for example, remains between the rate of increase in executive compensation and the pay increases most other employees get. In 2004, when the CEO's salary and bonus at the 350 largest U.S. companies increased 14.5% from 2003, the annual compensation for exempt employees at those firms was rising 3.4%, just over one-fifth as much, according Mercer Human Resource Consulting. During the last 10 years, only in recession year 2001 did pay for exempt employees rise (4.4%) while CEO salaries and bonuses shrunk, down 2.8%, but from a much loftier base than workers' pay.

IW 50 Compensation Plans
Percentage of long-term incentives in use at IW 50 companies.

Stock options only 36%
Stock options and performance-based long-term incentive plans 22%
Restricted stock and stock options 14%
Stock options, restricted stock, and performance-based long-term incentive plans 10%
None 10%
Restricted stock only 6%
Restricted stock and performance-based long-term incentive plans 2%
Performance-based long-term incentive plans only 0%
Source: DolmatConnell and Partners Inc.
And there is the entangled issue of whether compensation drives performance or is driven by it. "Where you source product, where you manufacture, [and] how you outsource -- those are probably no longer just sort of luxury items to contemplate. They are front-and-center, important, think-about-every-moment-of-the-day sort of things for industrial leaders," stresses Scott Kingdom, global managing director of Korn/Ferry International's industrial practice. But "I don't know if [compensation] is the chicken or the egg," he confesses.

"The fact is that if we want to be competitive, you're going to have to put certain products in the market that cost a certain amount of money and perform in a certain way -- period. There is no way to do that, in many cases, unless you seek to go outside the borders of the United States for certain parts of [manufacturing] -- either in the material itself, or the labor, or the assembly, or all," Kingdom says. "I don't know if compensation follows that -- or if the drive to cut costs sends you overseas. I suspect they are going on at the same time."

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish