How to Measure Your CEO’s Performance
from
September/October 2005
by Rob Norton
Filling in the chief executive officer’s annual report card has always been one of the toughest tasks facing boards of directors, especially the members of the compensation committee. While agreement is widespread that a CEO’s pay—both long-term and short-term—should depend on how well he or she does, getting the linkage right has turned out to be a delicate and tricky process. But it’s something boards must do, given the persistent pressure from institutional shareholders, government officials, and governance gurus.
Over much of the past decade, especially during the bull market of the late 1990s, CEO compensation became increasingly tied to shareholder returns. This linked the CEO’s fortunes to those of the owners, the theory went. Many boards grew addicted to rewarding chief executives with stock options, ensuring that the CEO would reap rich harvests if the stock price went up. That seemed fair enough. Trouble was, there was no corresponding pay reduction if the company did poorly—and some devious CEOs found ways to manipulate short-term movements in the stock price to make sure their options paid off. As a result, CEO compensation grew faster than underlying measures of corporate performance. But there are signs that those accelerating pay raises may have peaked (see “Market Bites Man in Corner Office” on page 43).
Some boards are moving away from total return and choosing more company-specific measures as a way to gauge how well their CEO is doing. In setting the short-term component of the CEO’s pay—the annual salary and bonus—compensation committee members can choose from a wide menu of such metrics. Some boards focus on one or two, while others use a mixture of as many as 10. These may include the company’s internal budgetary, strategic, and executive-development goals; financial measures like return on equity or growth in sales, net income, assets, or cash flow; and competitive rankings, such as the company’s increase in market share.
Zeroing in on a single metric has one great advantage: It’s simple. Boards can base the short-term component of CEO compensation on whether the company hits a particular target. At Biomet Inc. (2004 revenues: $2 billion), a manufacturer of medical devices with a notably lean approach to executive compensation, the board aligns executive pay with short-term performance by keeping salaries competitive and paying bonuses that can amount to half the annual compensation, tying them directly to performance against proposed budgets.
To keep executives from focusing unduly on the short term, the board also awards stock options based on how company stock is doing compared with its competitors’.
“There may be better plans,” says compensation committee chairman Jerry Miller, a principal at Havirco, an investment management firm in Kalamazoo, Michigan. “But we feel this has been effective in motivating people, and it’s something everyone can understand.” (For more on the Biomet system, see the box “The Good” on page 40. Examples of the bad and the ugly appear on pages 43 and 44, respectively.)
Another simple approach for the short-term component of a compensation package is to focus on a single trusted yardstick of financial performance. “At the companies I’m involved with, we use return on equity, and I think it’s a very accurate measure of performance,” says Fred Meyer, former CEO of Aladdin Industries, a privately held manufacturing concern in Nashville. Meyer is on the boards of four Dallas-based companies:
SWS Group Inc. (financial services), Palm Harbor Homes (manufactured-home building), Westwood Holdings (asset management), and the Oaks Bank. He feels that in 2005 an ROE of less than 7.5%, on average, should translate into no bonus for top managers, including the CEO. “But it scales up from there,” he says. “If you get up to a return of 20% to 30%, the bonus begins to get very large.”
As Diane Doubleday, a compensation expert in the San Francisco office of Mercer Human Resource Consulting, points out, “There is a host of financial metrics. Which ones are appropriate for any given company will depend on the company’s strategy and which metrics best capture the performance drivers in that circumstance.” In some industries, such as media, measures like EBITDA—earnings before interest, taxes, depreciation, and amortization—are more commonly used than net income or return on equity.
Of course, any measure that includes reported earnings is susceptible to manipulation by management. The hope is that newly alert audit committees, and boards generally, will be more on guard against such hanky-panky than in the past.
However the CEO’s short-term performance is measured, the compensation committee should also be prepared to use discretion, says Paul R. Dorf, managing director of Compensation Resources Inc. in Upper Saddle River, New Jersey. “Sometimes the numbers don’t tell the whole story,” he says. “You could have a great year because one of your competitors got blown out of the water, or you could have a lousy year that sets the stage for a great future.”
Determining the long-term component of a CEO’s pay, which usually takes the form of equity, is more difficult. For one thing, boards are moving away from stock options as an incentive, often because of the Financial Accounting Standards Board’s new requirement that options be expensed. Many compensation committees are replacing options with grants of restricted stock, which vest over a period of years. Peter Lupo, national compensation practice leader with Aon Consulting, says boards are increasingly making these grants “performance shares,” which are not awarded unless performance criteria agreed on by the board and the CEO are met.
For years reformers have pushed for CEOs to own a sizable stake in their companies as a way to tie their personal wealth to the companies’ success. Now some are saying “sizable” should reflect not the number of shares but a significant proportion of a CEO’s net worth. “Significant” translates as big enough for the CEO to feel the difference in net worth if things go well or badly. Fred Meyer, the Dallas independent director, thinks this is crucial. “You don’t go whistling through the park when it’s your own money that’s on the line,” he says, noting that the CEO of each of the companies on whose boards he serves has a major equity position. Meyer puts his assets where his mouth is. When he was asked to become CEO of Aladdin Industries, he agreed to take the job only if he could buy $1 million worth of company shares. Other companies with similar policies are formulating their definition of “significant” and going public with the numbers.
There are, however, reasons not to tie too large a share of a CEO’s long-term pay to the company’s stock price. “Individuals can’t always directly impact the share price,” says Paul Dorf of Compensation Resources. “You can get a scenario where a company has done very well, had the best results in its history, and the Wall Street analysts decide that the company will never be able to do it again and they sell the stock. That’s a very difficult situation for an executive.”
Diane Doubleday at Mercer Human Resource Consulting agrees: “If you’re trying to pick a specific time frame—say, three years—there can be a host of external factors influencing the stock price, so you can have a company that’s performing well but the shareholder returns are not reflecting it at that particular moment.” Doubleday believes that partly for this reason, “the mix in CEO pay is shifting to more of a balance, away from the emphasis on the long-term component and more toward salary and the annual incentive plan.” Mercer’s survey data show that long-term incentives fell to 62% of the overall CEO pay mix in 2004, from 71% in 2001. Over the same period, the portion represented by the annual bonus climbed from 13% to 23%. There may be an element of fine-tuning in this shift. A decade ago, big grants of options and other long-term incentives were touted as a cure for overemphasis on short-term results.
The final frontier of CEO pay changes may be the range of perquisites some boards add to compensation packages. These benefits, which often don’t have to be disclosed as prominently as salary, bonus, and long-term compensation, range from posh travel and housing allowances to gold-plated severance packages unrelated to company performance. “We’re only scratching the surface of the appropriate levels and disclosure of perks and benefits,” Doubleday says. “It will absolutely be coming under increasing attention.”
Board members themselves are among the people most critical of some of the outsize CEO pay packages that have featured in recent headlines. “I don’t want to criticize specific firms,” says Jerry Miller, head of the compensation committee at Biomet, “but some of these pay programs seem outlandish. It’s one thing to get rich if your shareholders are getting rich, but compensation needs to be tied ultimately to shareholder value.” Fred Meyer agrees: “I’m very irritated by the egregious compensation that many CEOs are getting in comparison with their performance, and I think the boards of those companies are doing a disservice to the business community.”
Media coverage, public opprobrium, closer regulatory scrutiny, and stiffer disclosure requirements are bringing more and more directors around to Meyer’s and Miller’s point of view. All the board members, executives, and consultants interviewed for this story agree that compensation committees are becoming more independent and assertive.
“Three or four years ago,” says Aon Consulting’s Peter Lupo, “two-thirds of our assignments originated from management, and developing the peer group of companies against which you’d gauge performance was usually a really quick exercise.” Now many compensation committees do their job much more intensely. “At least two-thirds of the time I’m reporting to the chairman of the compensation committee,” Lupo says, “and the peer-group exercise is scrutinized much more closely by the committee.”
An enabling factor for swollen CEO pay in the past was the stated intention of many boards to keep their CEO in the top quartile of the pay distribution in their industry. Sometimes referred to as the Lake Wobegon effect (after the mythical Minnesota village dreamed up by radio personality Garrison Keillor, where “all the children are above average”), this surefire recipe for CEO pay inflation is coming under increasing scrutiny, inside as well as outside the boardroom. “I think it’s nuts,” says Dennis Logue, dean of the University of Oklahoma’s business school and a director of Abraxas Petroleum, an oil and gas company in San Antonio, Texas. “I want the CEO to put the company in the top quartile of performance, and then we’ll figure out what we should pay him.”
Whatever specific metrics boards are using, evidence suggests they’re doing a better job right now of holding the line on CEO pay and tying it to the broadest measures of company performance. Mercer Human Resource Consulting’s latest annual study of CEO compensation found that in 2004 the median CEO salary increase at 350 large U.S. companies was a modest 3.7%. The median annual CEO bonus rose 20%, correlating closely with the median annual increase in corporate net income of 23%. Similarly, the median total direct-compensation package (salary, bonus, and the present value of long-term incentives) was up 17.1%, mirroring the median total shareholder return of 17.4%. Of course, if a CEO is already grossly overpaid, just keeping future percentage increases low doesn’t solve the problem.
No matter how carefully compensation committees regulate CEO pay, chances are there will always be criticism. Many critics of corporations are simply offended by the whole idea of multimillion-dollar pay packages. Perhaps the best advice for board members about CEO pay is to think more like politicians than businesspeople. When executives are appointed by the White House to senior positions at federal agencies, old Washington hands give them the following simple advice: Never say or do anything in office that you wouldn’t feel comfortable seeing the next morning on the front page of the Washington Post. When it comes to executive pay, board members should agree to a compensation measure only if they wouldn’t mind seeing it deconstructed on the front page of tomorrow’s Wall Street Journal.
THE GOOD: Biomet
For every company that grossly overpays its CEO, there are hundreds whose boards are more careful. One exemplar of modest CEO compensation is Biomet Inc., a manufacturer of medical devices based in Warsaw, Indiana.
Founded in 1977 by Dane A. Miller and three other entrepreneurs from the orthopedic industry, Biomet showed revenues in its first full year of just $17,000. But things have improved nicely since then. Today the company has 6,000 employees in 16 manufacturing facilities around the world, generating $2 billion in sales.
For 2004, Miller, still CEO, earned $300,800 in salary, a $275,000 bonus, and $17,388 in other compensation—a total of $593,188. As Biomet’s compensation committee explains in its annual report: “Over the years, Dr. Miller has received modest increases in his cash compensation, notwithstanding Biomet’s strong financial results. These [modest increases] reflect his cost-conscious management style and belief that the financial success of management should be closely aligned with shareholder interests through appreciation in the value of Biomet’s stock.” Miller has never received a Biomet stock option, but nearly everyone else in the company has—from senior managers to all hourly employees who have completed two years of service.
Not that Miller is poor; as Biomet’s co-founder, he owns seven million shares (2.8% of the outstanding stock), with a market value of more than $250 million. He just disapproves of excessive CEO pay. “I eat lunch in the company cafeteria and interact with people on the shop floor,” he says. “If my pay reaches a level that’s excessive, I might have trouble communicating with them.”
The dozen or so senior officers below the CEO and chairman level have pay packages not much lower than Dane Miller’s, says Biomet compensation committee chairman Jerry Miller (no relation), a principal at the investment management firm Havirco in Kalamazoo, Michigan, and an original investor. “We take care of their short-term incentives through yearly bonuses [tied to company performance] that can be as much as 50% of their total compensation, and they get stock options for the longer-term connection to shareholder value.” Simple, and smart.
THE BAD: Fannie Mae
The Federal National Mortgage Association—the giant federally chartered, publicly traded market maker in mortgage securities—says its business is “the American dream.” But investors were more likely to be experiencing a nightmare after the Securities and Exchange Commission determined in 2004 that the company had been cooking its books for several years. Fannie Mae is expected to make an earnings restatement that could wipe away as much as $11 billion, about 60% of its reported profits from 2001 to 2003.
The board forced Franklin Raines, then CEO, to step down last December, but it didn’t ask him to return any part of the fortune he had been paid for presiding over the shenanigans. Between 2000 and 2003, Raines received $70 million in salary, bonuses, stock options, and long-term incentives. According to an analysis by Lucian Bebchuk, director of the Program on Corporate Governance at Harvard Law School, and Jesse Fried, a law professor at Berkeley, more than $30 million of that $70 million was based on Fannie Mae’s inflated earnings.
Worse, Raines was granted a big retirement package as he was shown the door. The two largest elements were automatic vesting of 360,000 options to buy Fannie Mae shares (worth about $7 million) and a monthly pension of $114,000. Worse still, the board rewrote Raines’s employment contract just before he left, eliminating a penalty for “for cause” termination that could have reduced his pension by 25%.
Whether Raines gets to keep all that is up in the air. Several investigations, both civil and criminal, are under way. The Office of Federal Housing Enterprise Oversight (Fannie Mae’s chief regulator), the SEC, and the Justice Department are all looking into the company and Raines’s conduct, and several class-action lawsuits have been filed naming him as a defendant.
THE UGLY: Viacom
Viacom broke the news in its spring proxy that it was increasing CEO Sumner Redstone’s total annual compensation by 58%, to $56 million. This despite an 18% drop in its share price over the preceding year. A few days later the media company announced that its first-quarter net earnings were down, also by 18%.
Viacom said that it set executive compensation based on the company’s financial performance rather than the stock price, and that cash flow had increased 17%. Members of the compensation committee declined several requests for comment.
Corporate governance critics and security analysts derided the company’s justification for the pay package. The real explanation seemed obvious: Redstone had appointed two showbiz hotshots—Tom Freston and Leslie Moonves—as co-presidents and co-chief operating officers in mid-2004, after former No. 2 Mel Karmazin resigned to run Sirius satellite radio. Each of the newcomers got a total compensation package valued at $52 million; the compensation committee was just making sure that Redstone was still the top banana.
The Viacom board’s governance documents say all the right things about CEO pay. The compensation committee’s goals include “align[ing] executive and stockholder interests through incorporating incentives based on stock price”; the proxy states that the committee has “formalized a policy” and is assisted by “an independent compensation consulting firm with extensive experience in senior executive compensation generally and in compensation practices in the entertainment industry specifically.” In the end, though, numbers speak louder than words.
