Scandal fallout: tougher evaluation of CEO pay

As indictments and jury trials humble the reputations - and fortunes - of former WorldCom chief Bernard Ebbers and other once high-flying chief executives, a quiet change is taking place in CEO pay.

The scandals have done little to restrain hikes in executive salaries and bonuses. But corporate America seems to be adjusting by raising expectations for those paid handsomely - and not just expectations for the bottom line. Instead, corporate boards are redefining performance to include a host of factors from ethical behavior in the corner office to satisfaction of employees on the front lines.

Social performance, in other words, is starting to hit the business world's biggest wallets.

"One has to set not only financial goals, but also goals for how we're going to do our business and what kind of business we're going to do," says Pearl Meyer, a compensation consultant in New York. "We're giving people an opportunity to earn a stake in the business with good performance [in a range of areas]. I think you're going to get a better-run business over the long-term this way, rather than by hyping the price of a stock every day."

The idea: to shape leadership - and perhaps even mold moral character at the top - by customizing performance-based packages, experts say.

Five years ago, such nonfinancial considerations would have received no more than lip service, says Tom Wilson, an executive-pay strategist in Concord, Mass. "Now, nonfinancial measures are getting more people's attention because those are the leading indicators of financial performance. If your customers are satisfied, your employees are satisfied, and you're implementing different projects, you're going to produce financial results."

In his consulting firm's 2004 survey of 26 mid-size and large New England companies, 30 to 40 percent of performance-based bonuses had a link to nonfinancial factors, such as project results, customer satisfaction, or personal goals.

Performance-based bonuses made a splash in the 1990s as shareholders and directors aimed to rein in what were then skyrocketing market-driven packages. Since then, such incentives have been a mainstay of compensation packages, although critics charge that high-level compensation has continued to soar, especially through stock options.

But now, even stock packages come with additional strings attached. Instead of lavishing stock options on executives and lower-level employees alike, companies including Microsoft and Citigroup are cutting back on options as a perk of employment.

For chief executives, the trend is instead to award equity that is tied to company performance, says Diane Doubleday, a senior executive compensation consultant for Mercer Human Resource Consulting in San Francisco.

One example: to award restricted shares that vest only when the company reaches specified financial or operational goals.

"Eighteen months ago, I would have said, 'This is kind of cutting-edge. These companies that are moving in this direction are really market leaders,' " Ms. Doubleday says. "Eighteen months from now, the companies that aren't doing this are going to be really standing out as market laggards, if you will. So it's going to become the norm, and the companies that are not responding in some way to this are going to have to be explaining [why] to their shareholders."

On the surface, shareholders might find little reassurance in a trend that still enables chief executives to earn in many cases upwards of $10 million per year. In the last fiscal year, CEO bonuses alone jumped 28 percent to a median of $640,000, according to a sample of 233 companies analyzed by the Investor Responsibility Research Center in Washington, D.C. When stock options, restricted shares, and other sources are factored into the mix, median compensation packages approached $2.4 million for the year, the same analysis found.

CEO pay was the single most frequent target of shareholder resolutions in 2003 and 2004, and the 2005 proxy-voting season is shaping up to follow suit.

But in the move to broaden and customize incentives, some see a promising future.

For instance: Calvert, the nation's largest family of socially responsible mutual funds, is trying a new proxy tactic. It has filed resolutions pressing four companies to begin rewarding executives according to how well they meet the firm's own social goals, as well as financial ones. This could mean pay hikes for executives who oversee a surge in employee satisfaction or a drop in toxic emissions, to name a couple of possibilities. Response has been encouraging, the mutual-fund company says. Dollar General and Xerox have agreed to link incentives to their firms' social goals, moves that led Calvert to withdraw its resolutions.

Companies concerned with ethics are getting creative to see how much they can require in exchange for top dollar. The system has limits, Ms. Meyer says, since federal regulations require that bonuses be linked to quantitative measurements. But she's seeing companies set goals for organizational culture nonetheless. In those cases, a CEO's pay doesn't rise quite as much if the firm falls short of its cultural goals.

The trend in performance pay has its critics. Elaborate formulas with specific requirements have some chief executives "worried about being micromanaged by a board," Mr. Wilson says.

Others grumble that in the push to use performance as a carrot, one issue has all but disappeared: the ethics of paying leaders exponentially more than rank-and-file employees.

"It detracts from the dignity of the people doing the work of the organization" to pay a CEO at a rate several hundred times higher than an average employee, says Diane Swanson, a professor of business ethics at Kansas State University. "It causes alienation.... An alienated worker can passively sabotage the organization's goal."

In a 2000 study of 200 Australian executives, professor Swanson found a striking correlation. Those who expressed a preference for being paid far beyond what other employees earn were also the ones least concerned with matters of corporate ethics. Based on this, she recommends that companies screen out executive applicants on the basis of their pay preference in order to get leadership with scruples. Then, packages that encourage good behavior at the top will be most effective, and workers won't operate in a cloud of resentment, she says. "I would argue that executives earn their pay when they are attentive to these and other ethical issues."

But the purposeful practices of Vermont ice-cream maker Ben & Jerry's, where the average senior manager earns less than five times as much as the average manufacturing worker, have become something of a quaint anomaly in business. The reason, according to investors and consultants, is that artificial pay caps are unrealistic.

"We found the ratio to be rather arbitrary," says Nilloufer Daruwala, senior social research analyst at Calvert. "It just didn't get to the kind of results that we were trying to accomplish."

What's more, those seeking top talent won't get it if they constrain earning power to make a point, according to Meyer, the executive consultant.

"You're dealing with a market, and you have to pay market value," she says. "When you bring someone in and say, 'Save me,' you have to pay them.... While [pay levels] seem unethical or inappropriate, you have to get down to the reality of the situation."