Leadership by Geoff Colvin

How can we address excessive CEO pay?

April 13, 2011: 9:19 AM ET

Corporate boards and companies desperately need to rethink how they evaluate the way they pay their CEOs, and a few new methods just might help them do the trick.

By Eleanor Bloxham, contributor

FORTUNE -- CEO pay is headed skyward once again, leaving their non-executive minions far behind. Median CEO salaries jumped 27% in 2010 while overall worker pay increased by just 2.1% according to the Bureau of Labor Statistics, USA Today recently reported.

"The current levels of compensation for CEOs in corporate America are, in a word, outrageous," Jack Bogle, founder of The Vanguard Group, said to me in a conversation several years ago, a conversation that covered a number of topics, including the real levels of growth created by corporate CEOs.

CEO compensation practices at U.S. companies have been in the spotlight for a very long time. Back in 1977, Peter Drucker wrote that CEO pay should be no more than 25 times average worker pay. In a 1984 essay, he updated that to say that no more than 20 times average worker pay was appropriate.

"Widen the pay gap much beyond that, Drucker asserted, and it makes it difficult to foster the kind of teamwork that most businesses require to succeed", Rick Wartzman, director of the Drucker Institute, explained in an article for BusinessWeek in 2008 and, more recently, in a letter to the SEC.

Looking at the ratios closely, it's easy to see why there is so much concern about pay today. Following Drucker's principle, if a CEO earned $84 million for nine months work, as Phillipe Dauman at Viacom did (VIA), average worker pay at that company would have to be at least $4.2 million to be in lockstep with Drucker's ideals. If the CEO earned $22 million, as Howard Schultz the CEO of Starbucks (SBUX) did, average worker pay at that company would have to be at least $1.1 million. (Is that the going rate for baristas these days?)

Looking at it another way, if the average worker at a company earned $100,000, a board concerned with the same moral and social issues that concerned Drucker would limit the CEO's pay to $2 million or less. Based on the USA Today analysis, only 4% of the companies would meet that standard this year.

While executive pay has been a hot button management topic for years, it has only recently been in the sights of public policy makers. That's partly because a growing body of research has demonstrated the influence of compensation on CEO and worker behavior, a fact that many policy makers and members of the public woke up to in the aftermath of the financial crisis.

Yet despite all the gnashing of teeth over the last four decades, executive compensation issues have largely gone unsolved. During the recent financial crisis, investors had the opportunity to provide advisory votes on executive pay at financial firms that received TARP funds in 2009, and they gave thumbs up to pay packages at every single one of those institutions. This proxy season, with advisory votes now widely available (thanks to the Dodd Frank Act), only five companies' executive compensation packages have received a thumbs down from shareholders, according to Institutional Shareholder Services, a proxy advisory firm.

But do investors have all the facts they need to use their new say on pay appropriately? Could new metrics help motivate companies and shareholders to solve the intractable ethical and management issues Drucker wrote about years ago?

Better metrics couldn't hurt -- and there are a number of interesting ideas now under review. One new, and timely, metric being discussed in academic circles addresses the problem of incentives that encourage short-term behavior rather than the kind of actions that deliver sustainable corporate results. While companies typically use a mixture of short- and long-term pay incentives, a metric proposed by David Walker, a law professor at Boston University, would provide a measuring stick of the average term of pay.

Companies with a tilt toward providing long-term pay incentives would have a longer average term of pay than those who pay most of their incentives up front with no deferrals. The average term of pay metric would provide a simple way to compare companies' pay plans that would be useful to boards, shareholders and employees. This would also provide a reference point related to appropriate risk management and investment at the firm.

The Dodd Frank Act, passed last summer, requires companies to disclose the ratio of CEO pay to median worker compensation, which would also help stakeholders judge a company's pay plan.

At this time, the SEC has not yet made a proposal on how the new disclosure requirement will work. Nevertheless, the SEC is inviting comment on the rule. Some companies, and their legal advisors, are, unsurprisingly, suggesting that the requirement is not necessary, but the Drucker Institute is firmly in favor of the provision.

And there is good reason to think that the Institute is right. A recently released survey by MetLife puts in perspective the consequences of ignoring compensation issues.

According to the survey, employee loyalty at companies is at a three year low, which employers seem to be unaware of. Nevertheless, at companies with 500 or more employees, nearly 40% of employees "agree that if it's their choice, they hope to be working for a different employer sometime in 2011."

What drives loyalty or lack thereof? Nearly 80%  of the 1,412 employees surveyed for the MetLife report rank salary and wages as "extremely important" to their loyalty to the company. In fact, salary and wages was ranked as the most important issue to employees, outflanking advancement opportunities, company culture, work-life balance, and health and wellness initiatives by wide margins.

Given his views on the importance of pay and its impact on corporate functioning four decades ago, Drucker would not be surprised at these findings. And that's why the metrics proposed by Walker and mandated by Dodd Frank may just be the ticket.

Recalling the adage that "what gets measured gets managed," these metrics may be exactly what is needed to help boards and companies rethink the seemingly intractable compensation and related management issues that have dogged companies for decades. These metrics will also give potential investors and employees (who seem to be itching to move anyway) the information to make wiser decisions about where to invest and work next.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.

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About This Author
Eleanor Bloxham
Eleanor Bloxham
Contributor, Fortune

Eleanor Bloxham, an authority on governance and valuation, is CEO of The Value Alliance and Corporate Governance Alliance, an independent board and executive educational and advisory firm she founded in 1999. She is author of the books Value Led Organizations and Economic Value Management: Applications and Techniques, and publisher of the Corporate Governance Alliance Digest and her blog The Bloxham Voice.

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