What CEOs Are Really Paid

As you may recall from my last article, executive compensation has been a sticking point for many investors, especially in light of the large severance packages that both Bob Nardelli (the former CEO of  Home Depot (HD)) and Hank McKinnell (the former head of  Pfizer (PFE)) took with them when they were pushed out the door at their respective firms. While these are certainly egregious examples of "compensation gone wild," the defenders of existing pay packages for top executives can't ignore the fact that the average CEO in the S&P 500 in 2005 earned 350 times more than the average worker. Sure, this is down from about 500-to-1 at the beginning of the decade, but much of that deflation was due to poor stock market performance (which impacted the value of stock and option awards) rather than some overriding effort by corporate boards to rein in excessive pay packages.

While many of these abuses of shareholder capital could have been uncovered by digging through the multitude of regulatory filings and news stories surrounding the firms and their executives, there was always a lack of complete transparency behind the numbers (especially with regard to the impact that severance or change-in-control provisions could have on a company if they were actually exercised). As such, we're grateful to see that the SEC has made a concerted effort to force companies to provide investors with much more detailed information about top executives' total compensation, as well as the philosophy and objectives underlying compensation decisions. The SEC started to get serious about disclosure about four years ago, and the revised rules for executive compensation and related-party disclosure that took effect this year represent the culmination of these efforts.

The New SEC Rules on Executive Compensation
The overarching goal of the SEC was to provide investors with a "clearer, better-organized, and more complete picture of compensation for principal executive officers, principal financial officers, and the highest paid executive officers and directors." As such, the new rules require the disclosure of all elements of executive compensation: salary, bonuses, stock and option awards, incentive-plan payments, changes in pension values and deferred-compensation earnings, and all other forms of compensation (including perquisites and potential severance and change-of-control payments). The SEC has also required the presentation of "one bottom-line number" that reflects each executive's total compensation--a figure that the commission expects to be "comparable across companies."

While we're delighted with the level of disclosure that must now be provided, including a more detailed explanation by compensation committees about the objectives and components of a company's executive pay packages (reported in a new compensation discussion and analysis section, similar to the management discussion and analysis segment of each firm's Form 10-K), we think it may take some time to fully realize the impact that this new level of transparency will have on executive compensation.

The Law of Unintended Consequences
On the one hand, we expect the increased disclosure--especially with regard to things like deferred compensation and termination payouts--to create some eye-popping moments for investors, leading perhaps to greater calls for curbs in executive pay or shareholder votes on executive compensation packages. On the other hand, we think that there are several "unintended consequences" of the new rules that have yet to play out in the marketplace.

Many of the problems we face today with excessive pay packages for top executives are actually the result of the unforeseen consequences of legislation and regulations that were enacted (or not enacted) in the early 1990s. In an attempt to improve the transparency of executive pay packages (in reaction to what were perceived as excessive levels of compensation during the 1980s), the SEC adopted more stringent disclosure rules in 1992, and also confirmed the right of shareholders to question executive pay practices in annual proxy resolutions. In 1993, Congress decided that companies could no longer take tax deductions on executive compensation in excess of $1 million, unless the pay was performance-based. This coincided with the fight that companies were putting up against the efforts by the Financial Accounting Standards Board to make firms expense the value of stock options they were issuing to their employees. It also didn't help that the tax rate for gains realized from stock options was significantly less than the top tax rate for cash earnings.

While we believe that we are in a much different era these days than we were 10 or 15 years ago, we have to wonder if the increased transparency required by the new SEC rules for executive compensation disclosure might not create another wave of "me too" acceleration in executive pay. That is, as executives see how much their peers are making, we have to believe that some added pressure will be put on compensation committees to bring CEO pay packages in line with others in their peer group. This will only make the job of independent directors on compensation committees more difficult, as they seek a level that not only aligns with shareholders' interests, but also keeps the top executives from walking out the door.

More Transparency--More Clarity?
We also think that some of the changes in the disclosure rules have led to confusing and, in some cases, incomplete revelations for investors. For example, by expanding the summary compensation table to include a column for awards earned through non-equity incentive plans, the SEC has shifted what would have previously been reported in the bonus column to another section of the table. Shareholders will see a $0 amount in the bonus column (right next to the salary column) and may assume that the CEO (or other highly paid executive) did not receive a performance-based bonus for the year. If the company's stock performed poorly, they'll probably be happy. But they're missing the true story--which is that the bonus was probably paid, just not categorized as a bonus.

The SEC's requirement of only one year's worth of data in the revised summary compensation table could also lead to significant comparability issues. We won't deny that the inclusion of a total compensation column has improved the comparability of executive pay across companies, but by limiting the disclosure to just one year, the SEC has prevented comparability with the past pay practices of the individual firm. While some companies might actually offer up the last three years' worth of data in the summary compensation table, they'll be few and far between. As such, we're unlikely to know just how much compensation committees have altered their pay practices in the past year in order to place the compensation doled out to their top executives in the best possible (or least damaging) light this proxy season. That said, we still think that more disclosure is better than less, and certainly look forward to sifting through many of the filings as they become available this proxy season.

We have spent much of the past few months revamping our corporate governance grading system, and expect to be writing in much greater detail about the changes we've made in our next article. Until then, keep any eye open for changes to the Stewardship Grades of the companies we currently have under coverage, as they'll likely reflect the updates we've made to the way we look at companies and their management teams.