Editor’s note: Every Sunday, Fortune publishes a favorite story from our magazine archives. These days, CEO salaries make headlines and generally stir up resentment because they’re so huge. Even those who accept low official salaries, such as Chrysler’s CEO Sergio Marchionne who had a $1 salary for 2011, are quite comfortably compensated in other ways, for example, equity. This week, we look back to 1985, when FORTUNE called out how the paychecks of CEOs were getting much fatter much faster than those of other employees. Writer Monci Jo Williams explains some of the origins of the trend.
By trying to keep up with the Joneses, companies are hiking the boss’s compensation at a rapid pace. The independent directors on the compensation committee aren’t so independent, it turns out. And yes, the urge to please the C.E.O. plays a role.
by Monci Jo Williams
The compensation paid to America’s chief executives keeps increasing at a handsome rate. The phenomenon is a puzzler because pay inflation is slowing dramatically in the lower ranks (see chart). Why is the boss’s pay exempt from the general trend? The reasons turn out to be considerably more complicated than mere managerial greed–though that is indeed a problem at some companies. At the heart of the phenomenon is the use, or abuse, of salary surveys–studies of how much other companies are paying. The studies were supposed to provide a coherent statistical framework for what might otherwise be a highly subjective exercise. What the surveys have provided instead is a set of averages that most companies get an understandable itch to exceed. Who, after all, wants to be considered merely average? So the averages, and the chief executive’s pay, keep ratcheting upward year by year.
The trend lines on those charts don’t necessarily demonstrate that chief executives as a group are overpaid. In this unique job, the “right” salary–one that will encourage superior performance from which the company’s shareholders will benefit–is probably unknowable. For that matter, not every chief executive fits the trend and gets a raise–and some get fired.
But the boss’s raise–revealed in a proxy statement prior to that spring rite, the annual meeting–has been attracting extensive media coverage, most of it critical. As this has happened, the entire subject of executive pay has become so controversial that many companies, and many directors, were unwilling to discuss with FORTUNE how they determine executive compensation. Still others agreed to be interviewed, but only if their remarks were not attributed to them by name. As one corporate personnel executive explained it, “I’m very close to retirement, and I’d like to retire in peace.” The people who will talk for attribution are mostly the consultants whose survey data seem to have put their corporate clients on a smooth upward escalator.
From conversations with the players, it’s clear that most of American big business believes in a fairly standard model of how the chief executive’s pay is supposed to be determined. The process begins in the corporate personnel department, where the vice president in charge, or his deputy, assembles salary surveys put together by compensation consulting firms and others as a guide to the raises and incentive pay awards other companies are offering. The vice president looks at what the market is paying and at his own company’s financial performance, then makes a recommendation to the compensation committee of the board of directors on what pay levels might be reasonable. But the personnel executive’s ultimate boss is the chief executive, and that relationship might be thought to sway his opinion. So at most companies a consultant weighs in with a second opinion–based on his own collection of survey data–just to ensure that directors will get all the facts.
The surveys themselves are tributes to that old American fondness for sampling and statistics. Consultants survey companies continually through the year, collecting data on past and projected pay levels and increases in salary, bonuses, and long-term incentive pay. They then spew out an endless variety of surveys. One of the largest data banks belongs to the New York consulting firm of Towers Perrin Forster & Crosby: it puts out surveys on salaries, bonuses, long-term incentives, benefits, and perquisites, based on information from some 800 mostly industrial companies. Hewitt Associates, another consulting firm, offers a survey called Total Compensation Measurement, which covers the same types of compensation for about 300 industrial and financial service companies. Hewitt used to publish data about salaries and bonuses alone, but in the competitive quest to provide bigger and better surveys, has added information about perquisites, benefits, and long-term incentives as well. A few companies have even gone into the survey business for themselves. One consultant reports that a client compiled its own “Survey of Other High-Paying Companies.”
By the time a couple of sets of such documents are unloaded on it, the compensation committee is inundated with what one director says is “about six tons of data, certainly enough to make a decision.” The committee’s recommendation goes to the full board for still more discussion, and finally a vote. The chief executive is informed of the results only after his pay package has been approved by the full board.
The trouble is, the decision is almost never really made this way. In practice, contrary to the basic tenets of the model procedure, the chief executive often has his hand in the pay-setting process almost from the first step. He generally approves, or at least knows about, the recommendation of his personnel executive before it goes to the compensation committee, and may take a similar pregame pass at the consultant’s recommendation too.
Personnel executives and consultants say they have only rarely been pressured to change their recommendations to suit a chief executive. But the urge to please, though more subtle, can work to shape their proposals. Both, after all, rely upon the good graces of the chief executive for their livelihood. The consultant in particular–who is typically hired by management–would like to be invited back for a return engagement.
The board’s compensation committee doesn’t operate independently of the chief executive either–although it is usually composed of outside directors with the aim that it will: At a very few companies–Pacific Telesis is one–the chief executive is actually a member of the compensation committee. But at most other companies he just sits in on the committee meetings at the committee’s invitation. When the boss’s compensation is about to be discussed, the directors ask him to leave the room, but the committee’s decision rarely comes as a big surprise–and if properly done, perhaps shouldn’t.
Why do directors put up with this state of affairs so readily? Howard Waner, a retired manager of executive compensation at Exxon, says that directors are simply afraid to stand up to the chief executive. Graef S. Crystal, a vice president and compensation consultant with Towers Perrin, believes that directors feel compelled to please the C.E.O. because they regard him as EI Supremo on his own turf. Edward Delahanty, a partner with Hewitt Associates, points out that most directors are chief executives of their own companies. He believes that members of the compensation committee simply do unto the chief executive as they want their compensation committee to do unto them.
For such reasons, directors don’t need to be pushed around by the chief executives—they can usually find a few good reasons to raise his pay on their own. Consultants help in various ways. A few, such as Crystal and Louis J. Brindisi Jr. of Booz Allen & Hamilton, say they believe it is their job to advise the C.E.O. and the compensation committee how much pay is too much, and which long-term performance plans best measure and reward executive excellence. What does Brindisi do when faced with a client that he thinks is paying its top executives too much? “We up the performance goals and integrate them into the bonus system and the incentive plan,” he says. That way, the executives have to prove they’re worth the high pay. Other consultants don’t try to tell directors what’s best for the company and the shareholders. Says Michael Guthman, manager for compensation consulting in Hewitt’s eastern region, “We view ourselves as providers of information. We interview the board to find out their compensation philosophy and present them with alternatives in keeping with their goals.”
With surveys in hand and the C.E.O. looking over their shoulders, directors come up with a number of justifications for higher pay, many perfectly rational. Take a company whose performance is well above the average and whose compensation committee has adopted a policy of paying above the market rate. The committee gets its recommendations from the personnel director and the compensation consultant, each buttressed by plenty of data from several surveys. The committee members look at what competitors are paying their top executives, and at how well the company has done, and conclude that their policy of paying much more than the average is justified.
Across the street sits an average-paying company, whose performance is also just middling. The directors may look at the survey data, look at the company’s performance, and conclude that pay increases are not warranted. “But hold on,” one director argues. “We’re a quality company, and average isn’t good enough for us. We want to make a long-term investment in our people, hold the good ones, and be able to attract the best. We have to start paying more.”
A similar kind of logic may prevail at the company down the road that pays at the low end of the scale and whose performance is poor. The survey data come in, the directors look at the lousy performance, and pretty soon someone has suggested, rightly or wrongly, that part of the problem is paltry pay. “We aren’t competitive,” the argument goes. “We need to pay more, or we’ll lose the good people we have and our performance will suffer more.”
By the time the following year’s survey comes out, the market average has moved up. Even the low-paying company must pay more to try to avoid being at the bottom of the heap. It helps push everybody else’s pay scales upward too.
These annual exercises have had their inflationary effects not just on salary but also on the size of bonuses and long-term incentive awards. These days directors usually construct the chief executive’s pay package so that bonuses and long-term incentives account for at least as much as his base salary. The idea is to tie the bulk of the executive’s pay to the performance of the company, and thus to make him attentive to the shareholders’ interests. But many directors now view bonus awards and incentive payments as part of the total market price they need to pay to stay competitive. So when they raise part of the pay package, they have to adjust the other components to keep the proportion of base and incentive pay constant.
If the incentive plan is a sound one, with demanding performance goals, the shareholders’ interests will be served. Some of the best plans tie the payout to return on shareholders’ equity, a measure that over the long run acts as a powerful determinant of the stock price. But at too many companies, says Delahanty of Hewitt Associates, executives have come to view the payoff from incentive plans as “entitlements.” Indeed, when consultants are called in to overhaul compensation plans, it is often because the plans don’t pay out enough money. “Executives and directors know they must make some cosmetic effort to reward for performance,” says Delahanty. “But they want to make sure that plans are put in place so they will pay well.”
One way to do that is to structure plans so they require executives to do a minimum of stretching before the plans start to pay out. Most companies tie incentive plans to such measures as earnings per share-one of the easiest targets for management to manage. They avoid tough ones like total return to shareholders–dividends plus stock price appreciation. Many argue that this yardstick is too subject to the vagaries of the stock market.
Or a company can leave performance requirements entirely to the discretion of the board. Earlier this year the shareholders of Walt Disney Productions approved a stock incentive plan that allows the compensation committee to award stock, options, and stock appreciation rights. As to performance measures against which to gauge the Disney executives’ mettle, the proxy informed shareholders that “the committee may, but need not” establish them.
That’s not to say that Disney’s new president, Michael D. Eisner, doesn’t have goals to meet. In fact, he had such goals written into his employment contract. For starters, Eisner got a yearly salary of $750,000 and a $750,000 one-time bonus to compensate him for the benefits he lost when he quit as head of Paramount Pictures. His contract also grants him the option to buy 510,000 shares of Disney stock at the market price of $57.44. The stock was recently trading at over $77. The contract also stipulates that Disney pay him “an annual bonus equal to 2% of the amount … by which the company’s net income for the fiscal year exceeds a 9% return on stockholders’ equity.”
Many analysts laud the plan because it encourages Eisner to increase a measure usually critical to stock price: the more he improves return on equity, the more money he will pull down. Dave Londoner, a security analyst at Wertheim & Co., suggests, however, that coming up to the 9% benchmark is the equivalent of achieving “a C-plus average at a good college.” Disney’s return on equity may have been 8.5% in fiscal 1984, but it averaged more than 10% over the previous eight years. Security analysts say Eisner will meet his mark easily in fiscal 1985.
Some executives seem to wonder what all the fuss is about. When asked about his 1983 compensation of $1.1 million, GM’s Roger Smith reportedly replied: “Do people say, ‘I’m not going to listen to Michael Jackson now because he made $20 million’?” Such comparisons don’t cut much mustard with people outside the executive suite. Several compensation experts believe that by failing to address the issue of executive pay levels, corporate America invites continued criticism and government meddling. Congress has already slapped a penalty tax on some of the income executives get from golden parachutes–they pay out if the recipient’s company is taken over. As part of its tax proposal, the Treasury Department has also taken aim at the tax breaks on incentive stock options.
At least one chief executive has taken it on himself to hold directors accountable for the shareholders’ interests in setting managerial compensation. He is Jack MacAllister, a former chief of Northwestern Bell who inherited the newly created U.S. West regional telephone company after the AT&T breakup. Faced with the task of creating an entirely new compensation plan for an entirely new company, MacAllister decided to place the matter in the directors’ hands, and to leave it there. “My experience at AT&T convinced me that the usual process for setting pay puts management in control of the database, and that doesn’t give directors much lever-age in dealing with management or in representing the shareholders’ interests,” MacAllister says. He did let his compensation committee know he favored a salary level for U.S. West somewhere between that of utilities and more competitive companies. He also wanted an incentive plan that would tie bonuses and stock grants to how well the shareholders fared with the company’s stock. But he refused to discuss the subject further with directors, consultants, or the head of his personnel department.
The committee collected its own information and selected its own consultants, firing one because it was dissatisfied with an off-the-shelf solution to the problems of the new company. When Ed Delahanty, the consultant who was brought in to complete the job, made his recommendations, the committee thanked him for his efforts, saying they would figure out what to do from there. Delahanty says it was the first time in his 15-year career that a compensation committee did not adopt his recommendations wholesale.
What the committee ended up with was a performance plan that tied compensation directly to the shareholders’ interests. To be paid a bonus, MacAllister and the 67 other top executives at U.S. West and its subsidiaries must meet a combination of targets for net income, growth in earnings per share, and return on shareholders’ equity. In 1984 MacAllister was paid $380,000 in base salary and a bonus of $219,500. U.S. West’s long-term incentive plan calls for comparing, over three years, the company’s total return to shareholders with the return of companies in two different groups, the first a group of other regional telephone companies, the second a collection of corporate paragons such as GE, IBM, and 3M.
The idea–that a company’s executives will be paid well only when its shareholders gain–is right. If more C.E.O.s championed it as MacAllister did at U.S. West, or more compensation committees came to feel they had a responsibility to insist on it, executives might take a lot less flak when their raises are announced every spring.