by: Issues: May / June 2004. Categories: Governance.

The market is up, and the CEO is rewarded with a huge compensation package. The market is down, and the CEO is rewarded with a huge compensation package. There’s plenty wrong with this picture, not the least of which is the lack of any link between pay and performance, and the absence of any long-term performance measures. This author, a recognized expert in executive compensation, has several excellent suggestions for changing the picture.

Executive compensation at Wall Street investment houses encapsulates most of the problems surrounding excessive pay, as well as contributing a few of its very own. In this article, I will attempt to identify the key problems with executive compensation in firms both on Wall Street and in corporate America, as well as offer several solutions.

The three key problems this article will address are:

  • excessive pay levels
  • poor links between incentives and company performance
  • total lack of long-term performance measures.

1. Excessive compensation

The classic justification for high pay anywhere is that compensation is driven by the market: How can one company pay its executives less than its peers without incurring recruiting and retention problems? This too is the mantra on Wall Street, where pay peer groups range from the 50 largest U.S. companies (Goldman Sachs) to a small group of other investment banking and financial services companies (Merrill Lynch). The pressure on pay levels is pretty strong from both of these groups and the results of that pressure can easily be seen (see Table 1). But in the case of the investment banks, internal differentials – pressure from highly paid employees below senior management levels – can drive executive pay even higher.

While base salaries are generally low, they comprise a very small proportion of total compensation. As the Merrill Lynch 2004 proxy indicates: “Under the Merrill Lynch approach, like that of many investment banking/financial services firms, base salaries by design represent a relatively small portion of an executive officer’s total compensation.” Most of a Wall Street executive’s pay consists of incentive payments of one kind or another. Similarly, this is where the pressure arises from internal differentials, as the level of bonuses for many Wall Street employees, not just executives, can be substantial. According to the office of the New York City Comptroller, an estimated $10.7 billion in bonuses was paid out to securities employees in 2003. While this was divided among more than 160,000 employees, it is safe to say that some of those employees received bonuses that put their annual compensation close behind that of their bosses. Given these undoubted pressures, it is only fair that the CEOs of the six securities firms that have reported so far this year should have earned between $21 million and $54 million in 2003.

Fair from what perspective, exactly?

In the last two years, these six firms have been fined a total of $1.4 billion for publishing allegedly biased research; the grandson of Sanford Weill, the former CEO of Citigroup, was admitted to the 92nd Street Y preschool in exchange for a more favorable analyst report on AT&T, and several of the firms were involved in at least two of the biggest financial collapses ever, Enron and WorldCom (now MCI). None of the executives admitted any personal liability, and any and all fines were paid ultimately by the companies’ stockholders or the stockholders of the relevant insurance companies. Yet, by the end of 2003, the CEOs of the six largest brokerage houses that have reported so far are among the top 25 highest-paid CEOs in the S&P 500. Indeed, three of the banks – Citigroup, Lehman Brothers and Bear Stearns – have CEOs who are among the top 10 highest paid.

What justifies these levels of pay? The two most commonly reached for excuses are size and market. But evidence does not bear this out. With respect to size, only two of the banks are in the top 25 of the S&P 500 when measured by market capitalization. And it is only by a few million dollars that all six are in the top 250 companies of the S&P500. Size alone, then, cannot justify the pay that these CEOs receive.

Nor does the market these firms operate in provide any justification for excessive executive compensation. The median total compensation in 2003 for the CEOs of financial companies in the S&P 500 is only just over $6.4 million, well below even the least paid of the Wall Street CEOs. The only apparent justification then is the very small, self-perpetuating investment bank market. But we have already seen that neither market nor size, either singly or together provides any real justification for the current levels of CEO compensation (see the article “Are boards and CEOs accountable for the right level of work?” by Mark Van Clieaf, also in this issue of Ivey Business Journal).

Table 1 below gives the total compensation for the investment bank CEOs in 2003 and 2002. Stanley O’Neal, the CEO of Merrill Lynch, was the company’s COO in 2002. Nevertheless, only a small portion of the increase in his total compensation was due to his promotion.

The litany of excessive compensation, of course, is not limited to the CEOs of the Wall Street investment banks. The median increase in total compensation for a matched group of 228 S&P 500 CEOs between 2002 and 2003 was 27.16 percent. Median total compensation for the S&P 500 so far is more than $4.5 million. These figures follow immediately some of the worst securities and accounting frauds in recent decades. What has happened to the calls for pay restraint, for an end to the kind of excessive compensation so closely associated with those companies heavily implicated in the scandals of 2001-2003?

An explanation appears quite simple. Now that the stock market has shown some signs of recovery and firms have begun to improve their profitability, executive compensation can now continue its in exorable rise. This, of course, assumes that there is a link between pay and performance.

2. Pay-performance link

The second classic justification for high pay is that it is driven by performance. But in the vast majority of U.S. companies, the pay-performance link is not only broken, it was never forged in the first place. The year 2003 saw some of the highest earnings ever for Wall Street firms. The increase in bonuses for the CEOs – whether paid out in stock or cash – reflects this recovery in certain fortunes. Table 2 below gives increases in total annual compensation (the sum of base salary, annual bonus and other annual compensation). Henry Paulson, the CEO of Goldman Sachs, saw his annual compensation go down, solely because he received his entire annual incentive in equity, rather than the 55:45 cash-equity mix he received in 2002. Had the same proportion been used, his annual compensation would have risen by 82.54 percent.

It might have been thought that the more than 300 percent increase in annual compensation received by Lehman Brothers CEO Richard Fuld would have been the highest, but even this is dwarfed by the increase received by Citigroup CEO Sanford Weill. The change in his pay was largely due to his refusal of a bonus in 2002. It was never disclosed how much this might have amounted to, but it would appear that the receipt of $29 million dollars in bonus in 2003, along with a stock option grant with roughly twice the value of the 2002 grant, more than made up for any hardship he suffered in 2002.

While the level of increase at Citigroup is not common, it is important to note that there have been compensation increases of well over 100 percent throughout the economy, from retail banks to chemical, pharmaceutical and oil companies. Indeed, pay-growth has been substantial in the rest of the S&P 500, with the median increase in total annual compensation at 8.65 percent for a matched sample of 271 CEOs.

Although cash bonuses were the driving force behind pay growth for most CEOs in 2003, they were not the only force. For most Wall Street CEOs, the cash bonus only represents a portion of the annual incentive award. As has been seen in the case of Henry Paulson at Goldman Sachs, annual bonuses are also delivered in stock. Table 3 below shows the increase in the value of restricted stock awards for those CEOs that received them.

The level of increase in stock award for Henry Paulson would be only 258.7 percent had he received the same mix of incentive as in 2002. Sanford Weill did not receive a restricted stock award, because he was stepping down as CEO. But his successor, Charles Prince, did receive nearly $20 million in restricted stock.

Again, the rise in the value of restricted stock awards is not confined to Wall Street. In 2003, 116 CEOs received restricted stock awards compared to 99 in 2002. The median value of such awards in 2003 was $1,986,203, while in 2002 it was $1,462,000. Furthermore, for the 72 CEOs who received an award in both years, the median increase in the award was just under 25 percent.

3. An absence of long-term measures

It has already been stated that Wall Street had some of its highest earnings ever in 2003. This is the sort of justification generally given for the substantial cash and equity awards paid out in any successful year. It is also the kind of excuse given for wildly fluctuating levels of annual compensation, because significant changes in annual performance can effect significant changes in annual compensation. But surely, given the levels of award being made, some measure of long-term performance should be included. It is typical of U.S. executive compensation practices in general that only one investment bank – Merrill Lynch — has included any real long-term measures of performance in its incentive scheme. (see Table 4).

So, exactly what performance measures were used to justify these very high payouts? Table 4 gives the performance measures disclosed in the compensation committee reports for each of the six companies under examination.

As can be seen, disclosure levels range from the very poor at Citigroup, to the relatively comprehensive at Merrill Lynch. Return on equity (ROE) appears to be the measure of choice, which, given the nature of investment banking, is not too surprising. But Goldman Sachs and Lehman Brothers eschew this measure, choosing earnings and income, respectively. There are two significant problems with performance testing at these banks, however. Firstly, only two of the banks appear to have recognized that proper performance can be tested only by making comparisons with their peers. Surely any investment house can improve its income, its ROE or its earnings in a recovering stock market, or a bull market. A bank distinguishes itself only when its comparative ROE, or any other measure, is greater than that of its peers. But only Merrill Lynch and Morgan Stanley explicitly state that performance is compared to their peers. Secondly, only Merrill Lynch appears to include potential long-term value and growth measures in its list of bonus criteria.

This may well be a problem of disclosure. And once again, it is not a localized one. According to The Corporate Library’s database of executive compensation policies, 30 of the 155 S&P 500 companies that have been updated so far this proxy season do not disclose any annual performance targets. The descriptions of many others are cursory or inadequate. Surely this is a disclosure problem that should concern stockholders. Proper disclosure of the measurements of performance and proof that targets are truly standing the tests would go a long way towards:

  • creating trust between investors and management; and
  • increasing acceptance of high levels of pay where it is truly based on superior performance.

Of course, it will be claimed that awarding large portions of the incentive payments in the form of restricted equity of one form or another ties executives’ interests to those of stockholders in the long term. Citigroup states, for example, in response to a shareholder proposal calling for steps to curb excessive compensation, that:

“Citigroup’s equity compensation program, including the stock option program, is designed to align employee interests with those of shareholders. Stock options granted by Citigroup have an exercise price equal to the fair market value of the common stock at the time of grant. The value of these options depends upon the market price of the common stock: if the stock price does not increase, the options will be worthless; if the stock price does increase, the value of the options will increase as will the benefit to all stockholders.”

While this is true in the abstract, this does not make stock options or other equity awards inherently performance-related.

Stock options and restricted stock awards do not tie executive interests to those of stockholders either in the short or the long-term. It has been frequently stated that up to 80 percent of any rise or fall in a company’s stock price is due to the behaviour of the market rather than the performance of that company. But stock options and restricted stock should ideally reward superior performance. In order for this to happen, two questions need to be asked:

  • how much of any stock price increase is directly due to management’s actions?
  • how much, more or less, might stockholders have benefited had they invested in any other stock?

The answer to the first question is, potentially, only 20 percent of the stock price increase. But where is the stock option or other long-term equity scheme that rewards executives with only 20 percent of any stock price gain? And in answer to the second question, where are the equity schemes that only reward executives for long-term performances above the median?

Once again, the lack of any real long-term value growth measure is a problem that is not confined to the investment banks. Of the group of 155 S&P 500 companies already cited, only 58 have any kind of performance measure that goes beyond one year.

Solutions to each of these problems would seem to be relatively simple, albeit wildly unpopular. Firstly, boards need to address the absolute levels of executive compensation from a justifiable benchmark, utilizing a process such as the Level of Work and role complexity outlined in the Van Clieaf article already cited. Secondly, both annual and long-term incentive schemes need to be based on properly disclosed, real measures of long-term value creation, not the short-term operational measures used in the majority of cases.