Corporations Search for Answers on Executive Pay : Compensation: A reform plan for managers at General Dynamics illustrates the widening chasm between management and the public.

Former Apollo 8 astronaut William A. Anders, the chief executive of General Dynamics Corp., believed that his company had hit on a novel plan to motivate top managers when the board adopted a “gain sharing” executive-pay plan last February.

After all, the buzz these days is that companies should more closely tailor their compensation packages to corporate performance--as measured by total return to shareholders, or the sum of stock appreciation plus invested dividends.

The General Dynamics plan accomplished that swimmingly. It called for the top 25 managers of the Falls Church, Va.-based company to receive bonuses equal to 100% of their salaries the first time the company’s stock jumped 10 points above the $25 price at which it languished last February. Each additional 10-point rise would generate twice their salary. The only caveat was that each new price level had to be sustained 10 days.

Days after shareholders approved the plan in May, General Dynamics’ stock hit the magic number, held for the requisite period, and Anders and his lieutenants walked off with a $6-million reward.

The reason: The nation’s No. 2 defense contractor determined that the nation would need far fewer of its Atlas rockets and other Cold War weapons, and announced plans to lay off 30,000 workers by 1995. Investors, already riding the wave of a buoyant stock market, liked Anders’ strategy of shrinking his company ahead of Pentagon cuts, and rushed to buy the stock.

Anders was nonplussed when vituperative outbursts from institutional shareholders, workers and local communities rained down on his head. “Why is there just gain sharing for the 25--most of them relative newcomers--while people who have worked in the trenches for many years are losing their jobs?” sputtered an outraged Dean L. Girardot, coordinator of the International Assn. of Machinists, which represents workers at General Dynamics plants in Texas and California.

Added a United Auto Workers representative, “They’re really slopping at the trough.”

General Dynamics forged ahead despite the outcry and in October added insult to injury by announcing that its cash hoard was becoming so swollen through cost savings that the company would return excess cash to shareholders. The move set off a second investor stampede that bid the price up another 10 golden points, and the executives pocketed $12 million more.

Compensation expert Graef S. Crystal, who teaches at UC Berkeley’s Haas School of Business, summed up: “This ill-conceived plan smacks of the Marie Antoinette School of Management.”

General Dynamics’ experiment illustrates the widening chasm that has emerged between executives and the public over the issue of management compensation. Many investors and shareholders are asking why executives don’t take bolder steps to curtail lavish compensation arrangements, particularly when the economy is in recession and so many Americans are struggling to make ends meet.

Ross A. Webber, professor of management at the Wharton School of the University of Pennsylvania, marvels at the “asinine” spectacle of top executives pocketing large pay increases as their corporate profits slide. “Much of this outcry wouldn’t even have occurred if executives had simply made a symbolic gesture when profits began to drop, say cut their salaries by $100,000,” he maintains. “At their pay levels, such an action wouldn’t cause them pain.”

The Brobdingnagian pay levels of American executives drew slings and arrows from the Japanese during President Bush’s recent visit to Japan, feeding an already simmering protest. The result has been an escalation of the issue--which has previously surfaced during troughs in economic cycles only to recede as the economy regained strength--to visible political levels.

Mounting shareholder concern that high pay insulates executives from having to confront the serious problems their companies face prompted the Securities and Exchange Commission to issue proposals that could ultimately give shareholders a larger voice in determining executive pay.

Academics and compensation consultants have long contended that stock price is the best measure of corporate success, because it reflects judgments about the probable success or failure of management strategies. They argue that if corporations funnel more pay into bonuses that rise or fall according to those judgments, executives will be more likely to make hard decisions. The General Dynamics plan was an attempt to do that, and it still has admirers.

Says Kevin J. Murphy, associate professor at Harvard’s Graduate School of Business, “I love the plan in general. More than $1.1 billion in wealth for General Dynamics’ shareholders was created last year, and that’s very hard to do.”

Murphy argues that top managers must be rewarded for shrinking companies as well as growing them. “The hardest decisions a CEO has to make involve shutting plants and laying off people,” he says. “General Dynamics is in a declining industry. People don’t want as many of its products anymore.”

Detractors, including shareholder-rights groups and many analysts, believe that the plan suffers two principal flaws: no downside risk for management if the stock price falls, and the plan’s short-term orientation.

“There should be a requirement that the stock stay up a much longer period of time,” says Ralph V. Whitworth, president of the United Shareholders Assn.

Murphy contends that the point is moot because the stock price has ratcheted up another 12 points recently to close Friday at $57.875 a share.

Whatever the evaluation, General Dynamics finally bowed to pressure. Declaring that the plan had achieved its goal of reorienting corporate strategy, the company held an unusual special shareholders’ meeting last month at which a revised plan was approved.

The new plan substitutes stock options for cash bonuses. As part of the change in policy, General Dynamics awarded an additional $4.5 million to the plan’s participants.

Donald J. Jacobs, dean of Northwestern University’s Kellogg Graduate School of Management and a director of eight companies, points out today’s dilemma: While business suffers excruciating problems, the stock market is climbing higher each month. Since the pay-for-performance model tied executive pay to corporate stock prices, managers are cashing in.

“Is that fair?” he asks. “Well, it’s the way it was set up. But we never could have predicted this outcome.”

The complaint that the General Dynamics plan allowed executives to do wonderfully on the upside and wonderfully on the downside is a persistent one voiced about executive pay packages today. The issue exacerbates alienation among workers, feeding a “credibility gap” that troubles corporate analysts. Critics complain that compensation committees of corporate boards have built in gimmicks to shield executives from downside risk.

Standing in lonely isolation as an example of a chief executive willing to sacrifice along with shareholders and employees is John S. Reed, 53-year-old chairman of Citicorp. The nation’s largest bank holding company is struggling to assimilate a mountain of bad loans and, as a result, Citicorp’s stock sells in the mid-teens.

Reed has demonstrated an unusual concern for the suffering of his constituents. He has received no salary increase, bonus or stock option, based on Citicorp’s 1990 and 1991 performance.

Even more uncommon, Reed’s total pay actually has declined--to $1.2 million in 1991 from $1.8 million three years earlier.

Critics also were pleased when Reed bought $2.5 million worth of Citicorp stock with his own money, a gamble that will pay off only if he can steer his company to renewed profitability.

In the eyes of many, substantial executive stock ownership is the single most effective way to protect shareholder interests. It also correlates with success, according to a study by Alliance Capital Management. Mark Cunningham, a money manager with the big institutional investor, reports that companies in which executives own at least 10% of the shares generate superior earnings and long-term return to shareholders.

Warren E. Buffett, chairman of the holding company Berkshire Hathaway, has long championed the notion of owner-managers. Buffett owns 42% of the company he built; his shares are worth more than $4 billion, but he’s one of the lowest-paid executives in the country with a $100,000 salary.

In a 1991 survey of 1,000 of the nation’s biggest companies compiled by Crystal, Buffett landed on the list of the 10 most underpaid executives. Also on it are entrepreneurs who’ve built big companies--such as Bernard Marcus of Home Depot (1990 salary: $1.9 million) and Leon Hess of Amerada Hess ($300,000).

Crystal uses complex methodology to determine appropriate pay, including an assessment of return to shareholders over 10 years.

By his criteria, five companies have arrived at the right level of pay for their chief executives. They are: American Stores Co., the Salt Lake City retailer of food and drugs that owns Jewel Companies, Lucky Stores and Alpha Beta, as well as several drug chains; AmSouth Bancorp, a Birmingham bank holding company with 138 offices in Alabama; Hecla Mining, a miner of silver and gold based in Coeur d’Alene, Ida.; Pentair, a manufacturer of paper and portable tools based in St. Paul, Minn.; and Zenith Electronics of Glenview, Ill., the consumer-electronics manufacturer.

Compensation consultant Claude Kordus of Hewitt Associates in Newport Beach says El Segundo-based Mattel Toys has successfully tied executive pay to cash-flow targets. CEO John A. Amerman earned $1.2 million in 1991, a reward for turning his company around from serious troubles in the late 1980s. Mattel Toy’s average annualized compound return to shareholders from January, 1987, through December, 1991, was a sterling 35.09%.

What will it take to nudge companies into more responsible actions? Many business school professors, consultants and executives believe that real changes are under way, and that they will accelerate.

For one thing, big institutional investors such as the California Public Employees Retirement System (CalPERS), with its $67 billion in investment funds, will continue to exert pressure on pay issues. Those organizations are now backed by the strong arm of the SEC, which will ensure in the future that clear and understandable explanations accompany previously obscure plans.

Moreover, the august Business Roundtable, a business lobbying organization made up of 200 chief executives from the biggest U.S. corporations, has climbed aboard the reform bandwagon. The organization directed members through an unusual position paper to create pay packages with “a commensurate level of opportunity and risk based on business and individual performance.”

Compensation consultants report that the message of discontent has penetrated the executive suite. Says Kordus: “I believe more and more companies are working hard to build performance not only into top-level plans but in middle management as well. It’s not a majority yet, but it bodes well for the future.”

Peter Chingos, compensation practice partner at the accounting firm KPMG Peat Marwick, adds that for the first time in 20 years he is spending time alone with board compensation committees, who want to talk with him when the CEO is not around.

The outside board members are themselves often handsomely paid. Critics suggest that there’s a relationship: The higher the board members’ income, the larger awards they are willing to grant.

Wharton’s Webber believes that one solution lies in an idea currently gaining ground: Preventing the chairman of the board from also being chief executive.

This managerial system, widely used in England, achieves a distance that allows a chairman to monitor a chief executive and more effectively ally him with the interests of shareholders and the public. Buffett is examining the possibility of such a change at scandal-ridden Salomon Inc., where he has served as interim nonexecutive chairman since August.

Edward J. Zajac, an associate professor at Northwestern’s business school, believes that American CEOs care a lot about pay partly because compensation has become a scoreboard where dollars symbolize achievement. He sees a trend, however, toward greater executive comprehension of the public relations damage from huge compensation packages.

“Folks at the top are interested in leadership,” says Zajac. “One way you lead is through example. Chief executives can make major gains by becoming more aware of how their actions look.”