How to Pay CEOs What They’re Worth

5 simple reforms to bring bosses down to earth and help restore corporate credibility.

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When Stanley O'Neal stepped down as CEO of Merrill Lynch in November 2007, the company sent him out the door with $162 million, effectively doubling his earnings from nearly five years as chief executive. Over the next five quarters, Merrill lost more than $30 billion from deals that were largely brokered during O'Neal's tenure. Merrill's stock price was at $44 when O'Neal became CEO, $66 when he left in 2007, and $11 a year after he left, when a hobbled Merrill was taken over by Bank of America. O'Neal publishes his golf scores, but he's never taken responsibility for Merrill's implosion—or offered to return any of his money. And shareholders have no way of demanding it back.

This, of course, is a familiar, if grotesque, Wall Street story. Charles Prince earned nearly $160 million for serving as CEO of Citigroup for four years, even though he left the bank crippled when he departed in 2007. The company's stock price was $47 when he took over in 2003 and $38 when he left in 2007. Today, with Citi a ward of the state thanks to disastrous moves under Prince, the stock wallows at less than $5. Martin Sullivan pulled a similar stunt during three years as CEO of AIG, signing off on derivatives deals that ultimately wrecked the company, brought the global economy down with it, and required an $85 billion taxpayer bailout. Sullivan's reward? $100 million. Nice work if you can get it.

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CEOs weren't always entitled to nine-digit paydays for 11-digit losses, and we may finally be at a pivot point where CEOs get paid for building and running healthy companies, not just for showing up. The Federal Reserve and Treasury Department are developing rules that would link executive pay at 5,000 banks to the riskiness of their loan portfolios and long-term performance. Congress is readying other executive-pay rules that could be more severe. To head off intrusive government solutions, some industries and corporate leaders are proposing their own reforms, including a recent report by the nonprofit Conference Board prepared with input from big companies like Hewlett-Packard, Nucor, Kroger, and Caterpillar.

Fixing the problem of outlandish CEO pay isn't complicated, although anybody who wants to perpetuate the status quo could certainly obfuscate and make it seem that way. Here are five basic principles of reform that most experts agree on:

Link pay to long-term performance. O'Neal, Prince, and Sullivan earned millions for driving their companies into the ground because their bonuses and other incentives were linked to quarterly or annual results, not to the company's health in three, five, or seven years. That led them to take risks that boosted short-term performance without worrying about long-term consequences, which obviously didn't work out so well. Most proposals for reforming executive pay call for bonuses to be paid out over much longer periods of time, so executives focus on long-term stability. Compensation committees at each company need to devise specific formulas for measuring long-term performance, but in most cases it will be some combination of earnings per share, revenue growth, return on assets, and other metrics that reflect the company's financial health.

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Allow claw-backs. If you buy a computer or refrigerator that doesn't work out the way you expect, odds are you'll be able to get your money back. But CEOs have been able to wreck companies and walk away unscathed, without returning any of their pay. "Claw-back" provisions would give companies the legal right to reclaim CEO pay if unhappy surprises surface after the boss has pocketed bonuses and other compensation. That might dissuade CEOs from inflating revenues or profits to boost short-term results or concealing risks that could become a problem later on. "I automatically advise any board I work with to make claw-backs a part of their compensation plan," writes Brian Hall, a compensation expert and professor at Harvard Business School. "Why wouldn't you want the right to go after that money? This doesn't mean you don't trust your top executives. It's just good sound governance." Claw-backs are rapidly catching on even without new laws requiring them. In 2006, just 18 percent of big companies had claw-back policies, according to the Conference Board. In 2008, 64 percent of big companies did.

Shareholders need to be more involved. One way to empower shareholders is to enact "say on pay" rules that allow them to have at least an advisory vote on executive pay packages. But the image of widows and pensioners clinging to a few shares of stock while the CEO exploits their trust isn't quite accurate. The majority of shareholders in most companies are institutional money managers who don't necessarily buy and hold shares for the long term; they trade every day and dart in and out of companies to exploit momentary gains and losses. By some accounts, those institutional shareholders have contributed to an emphasis on short-term results rather than long-term performance. "Shareholders ... have a responsibility to avoid a 'check the box' approach to advisory votes on executive compensation and critically examine recommendations of proxy advisory firms," says the Conference Board.

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The Lake Wobegone effect needs to be curtailed. Most big companies hire outside consultants to evaluate what CEOs get paid at other similar firms, a practice that inevitably leads to pay inflation. The consultants typically determine a pay range for "peer group" companies, with a figure that represents median pay. But some critics claim that compensation committees, which are usually friendly to the CEO, often cherry-pick a peer group with the highest possible salaries. And even then, paying your own CEO the median implies that he or she is mediocre, so compensation committees often aim to pay their cherished leader at or above the 75th percentile for the peer group. As a result, most CEOs get above-average pay and the peer group median goes up and up, a practice that has boosted CEO pay to about $8.4 million per year, according to Hewitt Associates.

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Lavish perks should be reined in. The list of questionable CEO privileges includes huge severance packages that can be multiples of annual pay, unrestricted use of corporate jets, "gross-ups" that reimburse executives for taxes on perks that count as income, lavish "golden coffin" death benefits that accrue to families, and any other payouts not approved by shareholders. One rule of thumb would be to avoid any perk or payment that's generally controversial and, if in doubt, put it to a shareholder vote. Companies already seem to be heading in this direction. In 2007, according to the Conference Board, just 35 percent of firms allowed executives to use company aircraft for personal travel, a sharp drop from the year before, when 67 percent of big companies allowed it. But clipping CEO wings for a while doesn't mean they'll stay grounded. Another hand on the yoke would help.