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Wall Street Journal, March 21, 2007 editorial


The Wall Street Journal  

March 21, 2007


CEOs and Their Millions
March 21, 2007; Page A18

Proxy season is under way, and as companies file their annual reports we can expect a spate of "analysis" stories purporting to tell us just how much America's top executives are making. These stories will also purport to demonstrate that there is no pay for performance at the top of publicly traded companies by comparing stock appreciation with the pay as disclosed under a new SEC rule.

These stories will be wrong. This is so for the simple reason that the SEC's new standard is not designed to measure pay-for-performance.

Last year, the Securities and Exchange Commission promulgated a rule on executive-pay disclosure. On balance it is an improvement in transparency, but one complication is the way it measures the value of stock options as compensation. The SEC rule requires companies to set the value of options based on their "fair value" at the time of the grant. That number is then disclosed as compensation as the options vest, even though by then they could be worth a lot more or a lot less than their original "fair value." This will present big numbers for the media to chew on, but it won't say much about pay for performance.

Consider two hypothetical CEOs. In Year Zero, CEO Dow is given options on three million shares of stock, even though he's done nothing more than agree to run your company. The company has not backdated or otherwise monkeyed with the strike price, so the options at current prices are worth zero dollars, even though the company must record an expense and disclose some portion of the value of those options in its proxy.

CEO Jones runs a similarly sized company in the same industry, is hired on the same day in Year Zero, and likewise receives three million shares worth of options under the same terms.

Over the three-year vesting period for their options, both companies dutifully disclose that their CEOs, Messrs. Dow and Jones, are "paid" the same amount. But if the stock of Mr. Dow's company doubles in three years, his stock options are worth a lot of money. And if Mr. Jones's company's share price is cut in half, his options are worth nada.

Those two numbers -- "a lot of money" and "nada" -- are what matter to Messrs. Dow and Jones. It's not the accounting cost of the shares or some "total compensation" figure in an eight-column chart buried in a 50-page executive-pay disclosure form filed with the SEC that determines the size of Mr. Dow's mansion; it is whether he can monetize the shares given to him as an incentive to boost the stock price.

CEO pay packages are more than just options, of course. There's a salary and cash bonus. There may be deferred compensation and assorted perks. Some of those are performance-based, and some serve as a kind of retainer to keep the guy around and happy while his options vest and his deferred comp matures. But to understand whether a CEO is being paid for performance, you need to know not only what the board offered him last year, but whether his actual total pay -- the amount in vested stock, cash and bonuses that he could walk out the door with -- was well-correlated with the company's performance in recent years.

The SEC disclosures now being released don't tell you that. But one compensation consulting firm has looked at the numbers, and it has found that, while the system isn't perfect, it actually works better than is widely believed. Watson Wyatt Worldwide has been tracking trends in executive pay for years. What it has found is that a CEO's pay tracks a company's three-year performance pretty closely.

Thus, a company that offered its CEO a pay package in the middle of its peer group and had middling performance over the next three years ended up putting an average amount of money in its CEO's pocket. Companies that outperformed over those three years ended up with richer CEOs than comparable companies that underperformed, regardless of whether the pay package at the outset was low, medium or high relative to its peers.

Some companies do overpay. And Watson Wyatt's Ira Kay acknowledges that the Lake Wobegon Syndrome is present in some board rooms: Few directors want an "average" CEO, so they pay above the average for their group. While overpaying may not be optimal for shareholders, even "overpaid" CEOs, according to Watson Wyatt's research, do better when their companies do better. Which we thought was the idea.

The SEC's disclosure rule, unfortunately, does more to obscure these facts than to illuminate them. Take Messrs. Dow and Jones again. Suppose that in the previous three years, Mr. Dow's company went nowhere while Mr. Jones's firm had beaten the market by 20%. Is it right that they got the same "pay" this year as defined by the SEC? The question is easier to answer once you realize that, going forward, how much they are actually able to take home from that package still depends on their future performance, which is as it should be.

None of this is to say that there are no badly designed pay packages, and the new SEC disclosure rules may help shareholders sort the good from the bad. The danger is that the new information will be misused by reporters and politicians with a class-war ax to grind. So we thought we'd point out in advance what the new rules show -- and what they don't.

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