The Sarbanes-Oxley Act and the legislation that followed focused business leaders' urgent attention on matters of corporate governance. CEO compensation, one key area of governance, is being scrutinized by regulators, shareholders, academics, journalists and watchdogs of every stripe. And board members are feeling the sting of public criticism over executive compensation, according to a study of U.S. board directors conducted by Heidrick & Struggles International Inc., a Chicago-based executive search and leadership consulting firm, and the Center for Effective Organizations at the University of Southern California's Marshall School of Business. "Today's directors face public criticism over executive compensation and must comply with strict governance reforms, making their work more challenging and possibly less fulfilling," observes Theodore L. Dysart, managing partner of Heidrick & Struggles' global board of directors practice.
Nearly 40 percent of respondents surveyed believe that CEO pay is too high in most cases, up from 25 percent in years 1998 through 2001. This is three times the percentage who think CEO compensation is generally in line with CEO performance, competitive conditions and good economics. Not surprisingly, outside directors are more likely to feel that CEO pay is too high than are inside directors.
Eighty-one percent of board members say they favor strengthening the link between CEO pay and performance. However, when asked about the effectiveness of the compensation program for their own company's CEO, only 24 percent indicate some change is needed.
The research also reflects the decline in CEOs' power over their board of directors in the post-Sarbanes world. Seventy-five percent of boards now have an independent director who serves as lead or presiding director -- a dramatic increase from 49 percent in 2003 and 32 percent in 2001. And 81 percent of directors surveyed report that CEOs have less control over their boards than before.
But a more independent and powerful board remains unlikely to have a significant effect on controlling CEO pay. When asked about changes in CEO compensation over the next three years, approximately one-third of respondents expect no change, and over half predict a small increase. However, one development could change the future of CEO pay -- mandatory shareholder approval of all executive compensation programs, which almost half of respondents say could decrease CEO salaries to a great extent or to a very great extent.
Under what circumstances do board members deem high CEO compensation justified? Both company performance and CEO effectiveness should be key in determining the level of CEO pay, say respondents.
When asked to name the drivers of increasing CEO pay since 1980, participants cited the actions of compensation consulting firms (36 percent say that factor is very important, and more than a quarter of respondents believe it's extremely important), followed by creation of new stock and incentive compensation programs and "weak boards."
Critics of CEOs' paychecks believe that the programs designed by executive compensation consultants don't deliver performance value. "To justify their existence, compensation firms falsely perpetuate the myth that there is meaning to 'pay-for-performance,' " explains David S. Cohen, Ph.D., author of "Inside the Box: Leading With Corporate Values To Drive Sustained Business Success" (Jossey-Bass, September 2006).
"Compensation consulting firms have certainly created a market for themselves that facilitates excessive CEO compensation at poorly performing firms," says Dr. Craig G. Rennie, assistant professor of finance at the Sam M. Walton College of Business at the University of Arkansas in Fayetteville. "Entrenched managers at such firms prefer stealth compensation that directors, shareholders and analysts find difficult to value. However, capable managers at well-managed firms also use complex compensation packages that are tied to industry practices."
Compensation consultants are hindered in their efforts to create effective CEO salary programs by a shortage of credible information sources on pay-for-performance, according to Jack Dolmat-Connell, president and CEO of DolmatConnell & Partners Inc., compensation advisers in Waltham, Mass. "Frequently, some -- and even perhaps the majority -- of executive compensation consultants poorly construct comparative groups from which to compare client performance," he says. "Many compensation consultants use suspect data sources. Almost no executive pay-for-performance studies exist in the marketplace."
To what extent do substandard boards partake in the culpability? "Rather than weak boards who might give in to the whims of consultants and managements, we believe instead that boards utilize weak processes," remarks Dolmat-Connell. "First, boards historically spent far too little time on matters of executive compensation at most firms. Second, until recently, compensation consultants often reported to management rather than directly to the board. Finally, boards did not ask for, nor did consultants provide, tools to understand the total compensation recommended, or how that would vary based on multiple performance scenarios. Luckily, companies are beginning to address all three of these areas today," he illustrates.
"America has many of the best-run companies in the world," Rennie points out. "Our executive compensation packages are some of the most sophisticated anywhere. These accomplishments are related, and reflect the flexibility and sophistication that we employ in the design and implemen-tation of all aspects of business
management, including executive compensation."