Corporate America is in crisis. Scandals, bankruptcies, questionable accounting and the like are eroding public trust. Poorly timed or possibly even fraudulent stock sales by key company executives are igniting legislative action. The overall economy is struggling, the stock market is in a heightened state of volatility, and investor confidence has plummeted so low that CEOs are now legally required to sign a pledge of honesty.

As a result, all the goodwill created by corporate America with the gains of the 1990s has vanished. Executive pay is once again under heavy public scrutiny, and calls to link pay with accurate measures of performance are louder than ever before.

Executive pay, especially CEO pay, has become a lightning rod for this collapse in investor confidence for a number of reasons. CEO pay levels in a few instances have reached into the hundreds of millions of dollars for a single year, raising the question of whether any employee is worth that type of money — especially in cases of a company’s mediocre or even poor performance. There also have been recent examples of overstated profits or outright fraud. Such situations are compounded by the ability of executives to time the exercise of their options and the sale of their stock, and by the fact that stock options are accounted for differently from other forms of compensation.

We believe that the executive pay situation offers a key window into the corporate governance crisis facing America and, accordingly, provides a possible solution. The companies with the pay governance processes that are most transparent and most aligned will be the ones to inspire the most investor confidence.

Watson Wyatt research clearly and consistently documents that a company’s executive pay levels are directly and positively correlated with its financial performance. Companies that give their executives a greater stock incentive opportunity outperform companies with lower opportunity. We also have found that companies with high levels of stock ownership at the executive and other employee levels substantially outperform their low stock ownership counterparts. In fact, our research has shown that stock ownership is more effective than stock options in this regard.

The research in our 2003 Executive Pay/Stock Option Overhang study bears this out. In particular, our findings show:

• Companies with senior executives with high stock ownership financially outperform companies with lower executive ownership. This performance is measured by Total Returns to Shareholders (TRS), Return on Equity, Earnings Per Share (EPS) growth and Tobin’s Q, among others.


• Companies with high actual CEO pay have better historical financial performance, as measured by TRS, than companies with low actual pay.


• Both cash compensation and stock option profits are highly sensitive to shareholder returns.


• Stock options remain a positive factor in company and economic performance despite the current economic uncertainty and the fact that fewer options are now being exercised. However, our research also shows that companies with excessively large amounts of stock option “overhang” have lower returns to shareholders than companies with more moderate usage. In addition, the optimal point in stock option overhang has gone down dramatically for companies in the high-tech sector.

To better understand some of the concerns of investors, we have investigated the impact of executive pay and stock option overhang on financial performance. The world of executive pay could change in unpredictable ways over the next few years. We believe that our statistical research on pay, ownership and options could be helpful in setting the future direction.

This report details those findings. The first section focuses on executive pay; the second on stock option overhang. It is interesting to note that, if the rules for accounting of stock options change significantly (as we now think likely), it is possible that stock option overhang will become a less important measure. For now, however, these historically reliable gauges continue to offer valuable insights.