Why Do CEOs Make the Big Bucks?

Chief executive officers (CEOs) get paid lots of money for being the top employees in the company. Why do they get paid so much? Like athletes and actors, CEOs provide a level of talent that is required to produce the desired product – in this case, a strongly performing company. The skills and responsibilities that come with the job of CEO are extreme and the number of people who can fill these roles is limited. That is why the market has determined that people with these skills are worth a lot of money to their companies.

Only about 20 percent of a CEO’s pay is base salary; the rest is made up of incentives based on the company’s performance. The rationale is that if the company is performing well and the shareholders are making money, then the CEO should share in that success.

CEO pay sets a ceiling for the company

A CEO’s compensation package affects everyone within a company. Often it can be considered the yardstick by which all other employee benefits and bonuses are measured and negotiated. Moreover, the CEO’s compensation may be an indicator of how well the company is performing. This performance, in turn, could translate into a more generous compensation package for individual employees who are savvy negotiators.

When companies establish pay structures, they define the compensation for the highest- and lowest-paying jobs before filling in the compensation for the jobs that fall in between. In the traditional internal equity method of establishing a pay structure, the CEO’s compensation sets a ceiling for the company, and each level below is compensated at a comparably lower level. If you know how well the CEO is compensated, you can get a sense for how generous the company is likely to be toward other employees as well.

CEOs make most of their money through incentives

As a general rule, base salary accounts for just 20 percent of a CEO’s pay. The other 80 percent comes from performance-based pay.

Base pay for the core role and responsibilities of the day-to-day running of the organization. This amount is very often less than $1 million because the IRS has imposed tax restrictions on “excessive” compensation.
Annual bonuses for meeting annual performance objectives.
Long-term incentive payments for meeting performance objectives to be achieved for a two- to five-year period. These awards are sometimes described as performance shares, performance units, or long-term cash incentives.
Restricted stock awards as an incentive to assure the executives are strongly aligned with the interests of shareholders. Because restricted stock awards have an actual cash value when they are granted, the proxy table shows these in dollars, not in shares.
Stock options and stock appreciation rights (SARs) for increasing share price and increasing the shareholders’ returns. Options have very favorable accounting treatment for the company, which is why they are so common.

Total compensation for CEOs goes beyond cash and stock

Although typically excluded from pay calculations, executive benefits and perquisites are disclosed in the summary compensation table and the retirement plan section of the proxy. They include the following:

Supplemental executive retirement plans (SERPs), which may keep the executive whole (that is, make up the difference) or better from a tax regulation that prevents the executive from receiving a pension benefit that exceeds ERISA limits ($135,000 per year or less based on the pension plan). For a CEO making $2 million a year, a $135,000 benefit may be inadequate for maintaining a comparable lifestyle.
Executive insurance plans that provide a source of retirement income and a richer death benefit to the executive’s family. These plans are used to guarantee retirement benefits from bankruptcy. Unlike standard retirement plans that receive protection from bankruptcy by the federal government, SERP benefits can be lost in the event of bankruptcy.
Miscellaneous executive perquisites and other compensation for various programs or negotiated deals that don’t properly fit into the above categories, including perks such as country club dues and financial planning. These are often small numbers that disclose imputed income amounts for those additional special benefits, but can also include some very large amounts for items such as loan forgiveness, special insurance programs, relocation expenses, etc.

At most companies, most of a CEO’s pay comes from stock or stock option gains. At investment banks, most of it comes from annual bonuses. Companies that pay the lion’s share of compensation in the form of stock options may pay little or no retirement. You can tell by looking for a retirement table in the proxy statement. If the words “SERP,” “ERISA-excess plan” or “Top Hat plan” appear in the proxy, then retirement is an important part of the executive’s remuneration. If not, then the executives are expected to retire on their ability to make and save money on their cash and equity earnings.

Pay philosophies often tie pay to company performance

The company’s Compensation Committee Report on Executive Compensation contains specifics about your company’s compensation philosophy, which affects all employees. It covers the following:

How well your company pays relative to its peers.
Who the company sees as its peers
How the company’s stock has performed relative to its peers and to the stock market as a whole.
How the company prefers to reward its executives through its total pay practices, i.e., what proportion of an executive’s total pay comes from salary, bonus, stock options, and long-term cash plans
How the company measures its performance – net income (NI), earnings per share (EPS), return on equity (ROE), return on assets (ROA), revenue growth, etc.
What criteria are used for determining the size of bonus payments: corporate results, divisional results, individual goals; or whether payments are discretionary.

The degree to which your company is a success may be answered in the annual and long-term incentive payout columns in the summary compensation table. If you see large bonus payments, then it is likely that your company is successful. Stock option grants and gains are also important to look at. This information can be gleaned from three tables in the proxy statement: the stock option grants table; the aggregate option exercises in the last fiscal year and fiscal year-end option value table; and the total return to shareholders table. If there are large gains from stock option exercises and substantial amounts in both vested and unvested stock options, it may be an indicator that the company is well managed in the opinion of shareholders. Good five-year shareholder returns in the total return to shareholders table would certainly validate this opinion.

Cash compensation is the norm in nonprofits Nonprofit organizations

typically offer compensation weighted heavily toward base salary. In response to competitive concerns, bonuses are becoming more prevalent as are special tax deferral programs that help executives save for retirement. Unlike comparable programs in for-profits, very few of these programs are broad-based. Participation is limited to a select few.

Some watchdog organizations have been critical of the amounts paid to chief executives of nonprofit organizations. But these employers counter that they are competing for senior talent with for-profit organizations that can offer incentives such as stock options that are not available to them.

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