Pay Dirt: The Executive Pay System Is Broken

Financial crisis raises questions: How did we get here and can we fix it?

Banks had failed, the economy had slumped and the country was waging a costly war abroad. Yet executives continued paying themselves princely sums, forcing the president of the United States to speak out:

"No American citizen ought to have a net income, after he has paid his taxes, of more than $25,000 a year," he said, urging Congress to help him "keep personal and corporate profits at a reasonable rate, the word 'reasonable' being defined at a low level."

This wasn't Barack Obama. It was Franklin Delano Roosevelt in 1942, only a few months after the attack on Pearl Harbor.

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Compensation -- especially for the highest paid -- has been controversial for almost a century.

But after a year in which Wall Street firms paid $18.4 billion in bonuses while accepting more than $50 billion in government bailouts, many experts say the system may have finally blown itself apart.

"The system is broken," said Warren Batts, former chief executive of Tupperware Corp., Premark International and Dart Industries who used to sit on the boards of Allstate Corp (ALL), Sears, Roebuck and Co. and Sprint (S). "It needs some guiding principles."

Without such guideposts, executive pay has run amok. CEOs made 344 times more the average worker in 2007, according to a survey from United for a Fair Economy, which targets economic inequality. That's up from less than 150-to-one in 1992.

In 1988, the value of "mega-grants" of equity for CEOs averaged $1.47 million. By 2003, the average equity grant was worth $3.3 million. But the mega-grants of the late 1980s were one-off awards. Fifteen years later, CEOs were getting 2.2 times as much every year, according to consulting firm The Delves Group.

Perks, such as country club memberships, corporate jets, palatial offices and rich retirement packages, have multiplied.

Despite the system's goal of encouraging stronger performance, some companies, such as Washington Mutual (WAMUQ), move the goalposts when targets may be missed to make sure their CEOs still get hefty rewards.

Crisis Culprit

In the wake of the failure of WaMu and Lehman Brothers (LEHCQ), some say the system may have spun so far out of control that it pushes executives to adopt strategies that damage the companies they run, rather than improve them.

Berkshire Hathaway (BRK-A) Chairman and Chief Executive Warren Buffett said this month that the main cause of the current financial crisis was excessive compensation, which encouraged executives at financial institutions to take on too much leverage.

"The crisis exposed flaws in exec compensation, showing the system encouraged risk-taking without an appreciation of the ramifications, which in some cases were entity threatening," said Bob McCormick, chief policy officer at corporate governance advisory firm Glass Lewis. "In good times, executives get paid extremely well and in bad times they get paid just very well."

Buffett blamed large institutional shareholders for not speaking out enough against lavish CEO pay. He also fingered directors for rubber-stamping compensation plans and consultants for helping companies exceed the excesses of rivals, year after year.

Image Hurt

And yet some of these players already know there are problems.

An April 2008 survey of 162 company directors and 72 institutional investment firms by consulting firm Watson Wyatt (WW) found that three-quarters of respondents thought the current system had hurt the image of American corporations.

Eight-six percent of investors said the system had led to excessive executive pay and 61% of directors agreed.

Less than two-thirds of the directors said the system improved corporate performance, while less than 40% of the investors thought that.

Awkward

So if directors, investors and consultants know things need to change, why haven't they?

Executive compensation expert Jesse Brill says the main problem is that directors find it very difficult to tell CEOs they're paid too much -- even if they believe it.

CEOs often pick board members and some spend more time picking members of the compensation committee than other directors, Buffett said.

"The comp committee doesn't want to offend the CEO," Brill explained. "They don't want to say 'we love everything you're doing, but in hindsight we did stuff with your comp that needs to be changed.'"

"Directors I've spoken with are very apprehensive about having these types of talks with CEOs," he added. "It's very awkward."

Outside consulting firms survey what rival companies pay and this information is used to make sure CEOs get more than average. When this is repeated over and over, executive compensation rises inexorably.

These consulting firms are usually hired by the company, not the compensation committee. That often means they try to keep the CEO happy so that they don't lose a valuable client, Brill said.

Then there's the small army of internal and external lawyers telling CEOs that their pay packages are legal, Brill explained.

"All these different advisers cannot afford to say things directly in terms of what needs to be changed because they're saying this to the person paying their paychecks," Brill said. "That's very powerful."

Doing the Right Thing

What upsets Brill most is that the system preys on the vulnerabilities of human nature. Most CEOs aren't greedy and care a lot about the health of the companies they run, he explained.

"But when consultants and lawyers are telling them they're fine and in line with competitors, and the board is telling them 'we want you to take this money,' it makes it very hard for CEOs to say they don't want the money," Brill added.

Still, some CEOs are turning down parts of their big pay packages.

Best Buy (BBY) Chief Executive Brad Anderson asked the board of the electronics retailer not to give him any long-term incentive award in 2008. In recent years, he's also requested that his stock options go into a pool for other employees.

At Costco Wholesale (COST), the annual salary of Chief Executive James Sinegal has been set at $350,000 since 1999 and cash bonuses have been generally capped at $200,000 since 1997. Sinegal also tries to link his bonus to those of other employees who are eligible for bonuses at the big-box retailer.

Walt Disney Co. (DIS) Chief Executive Robert Iger turned down an extra $2.4 million that he was supposed to get because of the entertainment company's fiscal 2008 performance. He asked the compensation committee not to give him the extra cash, although he still ended up with a $13.9 million bonus.

The fact that some CEOs have to turn away compensation that's due to them in their contracts shows even more how the system is broken.

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