Edition: U.S. / Global

Executive Cash Machine; How a Pliable System Inflates Pay Levels

Published: November 8, 1998

BACK in 1993, Reuben Mark, chief executive of Colgate-Palmolive, received two million stock options in addition to his salary and bonus. Colgate's board explained that the huge grant was the only one Mr. Mark would receive until 1998.

But in 1996, Colgate hired two consulting firms, Towers Perrin and Hewitt Associates, to review the company's executive-compensation plans. The consultants found that Mr. Mark's long-term incentive package had fallen ''significantly below the median'' of companies they used for comparison. So in 1997, a year early, the board granted him 2.6 million more options -- a package it promised would have to last Mr. Mark through 2003.

In the grand scheme of things, giving Colgate's chief a new grant of stock options a year early is not such a big deal. Sure, his total compensation went up 83.5 percent annually, on average, over the last four years, while Colgate's total returns rose an average of 25.9 percent. But the company has outperformed the market, and the stock must keep rising for Mr. Mark to exercise his options at a profit.

Yet this and hundreds of other examples, each with their own twists, help illustrate how hard corporate America works to make sure that few chief executives feel underpaid.

Through an elaborate process fraught with conflicts of interest and marred by questionable assumptions, executive pay is often set with methods imported from Lake Wobegon, Garrison Keillor's imaginary place where ''all the children are above average.''

The issue is not just the hundred-million-dollar payouts that a few chief executives collect by reaping the rewards of huge stock-option grants. Nor is it simply that some executives whose companies do poorly are nonetheless richly rewarded.

Rather, an examination of the interplay among chief executives, corporate directors and the consultants who help set pay levels calls into question whether ''pay for performance'' -- the mantra of executive compensation for the last two decades -- has been distorted almost beyond recognition by the maneuvering that goes on behind closed boardroom doors.

Performance certainly plays a role in executive compensation. But other forces conspire to escalate pay beyond anything performance strictly justifies:

* By setting their chief executives' pay above the median of whatever peer group of companies they choose for comparison, boards constantly ratchet up the compensation base line. If all companies in the peer group aim to pay in the top quarter of the group, for example, that level will just keep rising.

* Top executives, rather than the board of directors, typically control the hiring and firing of consultants who are brought in to design pay packages.

* Many directors who sit on their board's compensation committees have ties to management that raise doubts about their independence and objectivity.

* Boards justify raises by saying they have to pay their chief executives ''competitively'' in order to retain them, even if those executives are underperforming.

Such mechanisms work against anyone trying to set compensation at appropriate levels, said Robin A. Ferracone, president of SCA Consulting, a compensation and management consulting firm based in Los Angeles. ''Those forces tend to loom large and lead to abuses,'' she said. ''And when you have a whole string of them, shareholders haven't gained a thing. Instead, they've paid out a ton of money to keep people around who are underperforming.''

The confluence of all these forces is reflected in a study conducted for The New York Times by Graef Crystal, who edits a San Diego-based newsletter on executive compensation.

Mr. Crystal looked at the performance of 383 large companies where the same chief executive was in office from 1993 to 1997. An investor who put $100 in those companies at the end of 1993 would have had $202.10 four years later, for an annual return of 19.2 percent. If the pay of the companies' chiefs tracked that performance, their average compensation would roughly have doubled, from $2.78 million in 1993 to about $6 million four years later.

In fact, according to Mr. Crystal's analysis, the executives' pay climbed 38.1 percent a year, to an average of $10.1 million.

Who is to blame for this gap between pay and performance? Experts in both pay and corporate governance say that there is no single culprit -- except, perhaps, unchecked human nature.

''It's not evil of management to seek the highest possible pay package they can, because we all try to maximize our value,'' said Charles M. Elson, a professor at the Stetson University College of Law in St. Petersburg, Fla., and a director of three public companies. ''And it's not evil for a compensation consultant to have an affinity for management. Nor is it evil for a director to feel an affinity for the C.E.O. who appointed them. But it's a process that creates a one-sided result.''

To be sure, pay consultants say many directors have become more vigilant in recent years, in part because rich compensation packages have often come under sharp attack by large shareholders, including pension funds.