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Executive pay jumps as companies use options
It's good to have options.
Defying recession, the worst performance by corporate earnings since the Depression and another down year in the U.S. stock market, the chief executives at Chicago's largest companies received a double-digit raise overall last year, largely due to higher incentive pay, especially options.
In the ebb and flow of trends in compensation, cash packages were roughly flat last year, with many CEOs collecting smaller bonuses or none at all. But stock and options pay swelled as directors bestowed more long-term performance incentives.
In the end, executives' interests were, at least in a relative sense, aligned with shareholders': The median share gain by local companies was only slightly lower than the median pay increase. And executives presiding over the companies with the best-performing stocks saw total compensation jump nearly 14 percent overall, though the cash portion was essentially unchanged, while chiefs of the worst performers in terms of shareholder return had a 7 percent increase, with cash pay declining more than 10 percent.
Shareholder advocates, however, are nonplussed to see executives at poorly performing companies in line for a raise.
"Options awards continue to grow, so that if a company cuts back on a bonus, it frequently makes up for it" with options or restricted stock, said Ann Yerger, research director for the Council of Institutional Investors.
"With the market down, it was important this year to see some evidence that executives were sharing the pain, but in many cases companies made up for the shortfall with other types of compensation."
The Tribune's annual salary study of Chicago's top 100 companies by market capitalization, conducted with Mercer Human Resource Consulting, shows:
- The median salary of chief executives rose 5 percent, to $600,000, in 2001.
- Total cash pay--salary, bonus and other payments--declined 0.5 percent, to $1.08 million.
- But the median 2001 total compensation package--cash pay plus restricted stock grants, the estimated value of stock options granted and other long-term incentives--rose 11.5 percent, to $3.4 million, besting the 7 percent increase in 2000.
- On top of that, 40 percent of the CEOs exercised stock options last year, for a median gain of $1.6 million each.
At the top of the local pay heap was a whopping $43.1 million package awarded to the new CEO of CDW Computer Centers Inc., John Edwardson. The former UAL Corp. executive joined the Vernon Hills-based computer equipment seller in January 2001, negotiating a salary and bonus package worth $1.4 million, a 2001 stock option grant valued at $38 million and restricted stock worth $3.7 million.
Of course, Edwardson isn't guaranteed that payout--the restricted stock vests over a four-year period, and the options vest over five years. But things look pretty good: When he took the job, the options were priced at $36.85--when CDW shares were at one of their lowest points in more than a year. Now, the stock is trading above $50.
The estimated value of those options ranks Edwardson's package as one of the biggest in Chicago history. In 2000, Bank One granted Jamie Dimon options valued at $57.8 million as part of a $62.3 million package, and Motorola granted options valued at $42.6 million to Christopher Galvin as part of a nearly $59 million package in 1999. In Robert Morrison's first year at the helm of Quaker Oats in 1997, he received an options grant valued at $30.2 million and $5.7 million in restricted stock.
Overall, Chicago's biggest companies had a median 9 percent total shareholder return during their fiscal year, far better than the double-digit loss sustained by the benchmark Standard & Poor's 500 in 2001, but smaller than the 12.4 percent total return by the top 100 the previous year.
The 2001 compensation data, being disclosed to shareholders in company proxy materials ahead of annual meetings, comes as Corporate America continues to report disappointing earnings, and the stock market stays stalled in neutral.
Up in arms
Shareholder advocates are preparing for a contentious annual meeting season, raising challenges on issues ranging from corporate disclosure to auditor independence and conflicts of interest among directors. Pay experts also expect a backlash over compensation when shareholders learn executives of underperforming companies still can come out ahead with rich options programs.
Pearl Meyer, a leading compensation consultant in New York, expects to see companies rein in options grants in the coming year as shareholders declare the pay-for-performance pendulum has swung too far--nearly 60 percent of total executive pay now is based on stock price movement. She also expects new regulations requiring shareholder approval of stock option plans.
But companies and pay consultants say the system is much better today than in years past because the salary numbers are increasingly linked to results that shareholders must live with.
"A lot of the entrepreneurial ventures [of the 1990s economic boom] would not have been founded without the ability to use stock options," Meyer said.
The options bonanza got rolling in 1993 under a new law that cut off tax deductions for executive salaries that went above $1 million. It didn't apply to deferred compensation or awards tied to performance. Also encouraging the use of options: They don't have to be listed as an expense on the income statement, which reduces profits.
"The accounting and tax drivers make options relatively cheap, and they are aligned with shareholders' interest," said Rene King, a Mercer executive in Chicago who helped oversee the study.
But the link appears indirect, at best, say shareholder advocates.
"The story remains the same," Yerger said. Though most companies have implemented performance measures, she said, many have myriad other ways executives can make up for any shortfall, including options programs and generous corporate loans.
Yerger's Council of Institutional Investors voted last month to endorse a proposal before Congress that would require companies to include options expenses in their earnings calculations, reversing its position on the matter.
"Before there was a sense that it wasn't really a cash outlay, so as long as they were disclosed, it was OK," Yerger said.
Risk to stock values
Today, the stakes are higher. Incentive-based, or "at-risk," pay is becoming a bigger piece of executive compensation--58 percent overall--and is making the value of pay packages much larger.
Not so long ago--1993 and 1994, for example--the total cash compensation of the CEOs of the Chicago area's 100 largest companies actually was larger than the combined value of option grants. In 1993, well over a third of the top 100 companies didn't award any option grants at all.
That was then, of course. Last year, only a handful of CEOs received no options, and the combined grants were valued at more than $300 million.
But as stock options have grown to unprecedented levels for chief executives and, in some cases, on down the line to thousands of employees, they represent a dilution risk for shareholders.
Options represent 16.3 percent of all outstanding shares at the 200 largest U.S. companies, according to Meyer's firm, Pearl Meyer & Partners.
This so-called "overhang" was just 5.4 percent in 1990, according to Watson Wyatt Worldwide, a consulting firm. In fact, the firm notes in a recent study of the issue, the growing use of options may have accounted for a significant piece of the stock market's historic 1990s bull run.
"The use of stock-based incentive compensation has helped drive the increase in stock market performance," the report said, nodding to the increased productivity of American workers as they behaved more and more like company owners. Conversely, it said, excessive reliance on options has a dilutive effect on shareholders and tends to make executives more prone to taking riskier actions to boost stock prices, if only temporarily.
If there's any good news in that trend, it may be that shareholders are waking up to the problem and demanding a reconciliation, said Andrew Goldstein, central division practice leader for Watson Wyatt.
"While overhang levels have increased, the pace at which they are growing is leveling off," Goldstein said. "The market has begun to realize that higher levels of overhang do not produce higher returns."
Low-ball earnings targets
Meanwhile, attention is just beginning to turn to another issue in the corporate numbers game: budgeting.
With compensation frequently tied to earnings and other financial measures, managers often set artificially low targets so they can beat their numbers and reap higher pay packages.
The practice is extremely common, said Michael Jensen, professor emeritus at the Harvard Business School and author of a recent Harvard Business Review article on the subject.
Corporate budgeting "encourages managers to lie and cheat, low-balling targets and inflating results, and it penalizes them for telling the truth," Jensen wrote.
In an interview, Jensen said he's long argued that executives were, if anything, underpaid, and that the system needed to be fixed. Today, after dramatic pay hikes in recent years, he says executives are no longer underpaid, but that they are paid in the wrong manner.
"It does seem the system is broken," he said. "You find lots of people whose compensation has gone up at a time when market performance has been miserable."
Meyer, the pay consultant, has an idea for change. Design pay packages with 10 percent coming from straight salary; 30 percent from business performance on issues like market share, product development and strategy; 30 percent on financial results; and 30 percent on stock market gains or losses.
Jensen's idea: Get rid of corporate budgeting targets altogether and make pay a linear function of actual results, and spread payouts over longer time periods.
"I'm still a fan of rewarding managers on stock price, but spreading out [options gains] will make it more difficult for managers to be swayed to make short-term decisions," he said.
Tribune staff reporter Andrew Countryman contributed to this report.
A look at trends and issues affecting Chicago's Top 100 public companies.