CEO Pay: A Window into Corporate Governance

AMONG THE MOST-TALKED ABOUT compensation reports this year is the $1.6 billion option package for UnitedHealth Group CEO William McGuire at a time when more than 40 million Americans lack health insurance. Former Exxon CEO Lee Raymond retired with a $400 million package as consumers face soaring gasoline prices.

According to a survey prepared by Mercer Human Resource Consulting for The Wall Street Journal, total direct compensation for CEOs at 350 top corporations grew 16% in 2005. That was down from a 41% increase in 2004, but well over the 3.2% hike in wages and benefits for U.S. workers overall last year.

Median direct compensation, including salaries, bonuses, restricted stock grants, and gains from option exercises and other long-term incentive payments, was $6 million. Pay for CEOs at the 10 businesses with the highest shareholder returns grew by 51.3% to more than $10.2 million. The 10 CEOs whose shareholders took the biggest hit last year suffered a 72.5% drop in compensation to less than $1.6 million, according to the Journal.

Wharton accounting professor Scott Richardson says investors are increasingly paying attention to compensation as a window into the broader make-up of the firm. "I view compensation as part of the governance structure—how stakeholders in the firm make sure they don't get screwed over by management." He notes that the strongest link to executive pay is the size of the firm, with larger firms offering their CEOs higher pay packages.

Disclosure is key, he stresses, using Lee Raymond's Exxon retirement package as an example. That type of package is "fine as long as [boards and executives] contract up front, as long as it's disclosed to stakeholders and as long as the stakeholders have a right to question the pay structure." He says Raymond's terms were known at least four years ago, before skyrocketing oil prices made the price of his options increasingly valuable. "It's a lucky outcome for him, but that's the way it goes," says Richardson, pointing out that swings in long-term compensation can be particularly volatile in commodity-based businesses with less price elasticity.

Conflicts of Interest
Outside consultants play a critical role in determining compensation, says Wharton management professor Martin Conyon, noting that a compensation committee made up of independent directors usually sets CEO pay. As outsiders, these directors rely on expert advice from professional firms that track salary trends at peer companies.

While management is not involved in these discussions, the system can create an opportunity for conflict-of-interest problems because executives use the same firms to assist in developing strategies in other areas, such as human resources planning or pension design, he says. "One can imagine a scenario where the consultants would err on the high side on executive pay because they don't want to lose this other lucrative business. If you lowball the CEO's pay this year, your probability of being hired next year is jeopardized."

Conyon suggests that the problem would be solved if companies disclose which firms they use for compensation consulting. The argument against disclosure is that firms want to protect the privacy of their own consultants. "To my mind, this is a weak argument," says Conyon. He notes that in 2003, British corporate law was amended to require that companies name compensation advisors in their annual reports.

Conyon is not necessarily opposed to companies using the same consultant for compensation work and other parts of the business because there could be efficiencies in doing so. He also notes that most large consulting firms generally are careful to avoid conflicts in order to protect their reputation, particularly following the accounting firm scandals at Enron and other companies. "The approach to take is the one that creates greater transparency," he says. "Put the case before the investors to evaluate."

Conyon also disputes assertions that consultants contribute to an inevitable march upwards in CEO compensation. Others have argued that consultants create an institutional creep in salaries by the way they group companies for comparison and determine the market rate of pay.