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Originally published October 15, 2011 at 10:01 PM | Page modified October 16, 2011 at 9:56 AM

"Lake Wobegon" effect: When all CEOs are above average — pay wise

Researchers have found that about 90 percent of major U.S. companies expressly set their executive pay targets at or above the median of their peer group. This creates just the kinds of circumstances that drive pay upward.

The Washington Post

Lake Wobegon effect examples

At Adobe Systems

Chief Executive Shantanu Narayen earned $12.2 million in 2010 despite the fact that shareholder returns have been negative over one- and five-year time frames. A key driver? The compensation committee decided that Narayen should be paid at the 90th percentile of peers.

At Discovery Communications

The pay for Chief Executive David Zaslav has jumped from $7.9 million in 2008 to $11.7 million in 2009 to $42.6 million in 2010, making him the highest-paid executive in the Washington region.

In part, this is because the company aims executive pay at between the median and 75th percentile of peers.

Moreover, Discovery chose much larger companies for comparisons. Discovery's revenue was $3.8 billion last year, but it chose as "peers" such companies as Time Warner Cable, which had five times as much revenue; CBS, which is more than three times as large; and DirecTV, which is six times as large, according to data from Equilar, the executive compensation-research firm.

At Countrywide Financial

Then-Chief Executive Angelo Mozilo earned more than $180 million as he led the company to the brink of ruin during the five years before the housing bust. At times, his pay had been set at the 90th percentile of peers.

Mozilo blamed "the left-wing anti-business press and the envious leaders of unions" for putting pressure on corporate boards to restrain executive pay. Cutting executive rewards, he said, would discourage talented leaders.

quotes Since when is the CEO the most valued employee in a company, any company? Most CEO's... Read more
quotes "Since the 1970s, median pay for executives at the nation's largest companies has... Read more
quotes Come on...does this guy really need to make over 300 times my annual salary? Read more

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THOUSAND OAKS, Calif. — As the board of Amgen convened at the company's headquarters in March, Chief Executive Kevin Sharer seemed an unlikely candidate for a raise.

Shareholders at the company, one of the nation's largest biotech firms, had lost 3 percent on their investment in 2010 and 7 percent over the past five years.

The company had been forced to close or shrink plants, trimming the workforce from 20,100 to 17,400. And Sharer, a 63-year-old former Navy engineer, was already earning lots of money — about $15 million in the previous year, plus such perks as two corporate jets.

The board decided to give Sharer more. It boosted his compensation to $21 million annually, a 37 percent increase, according to the company reports.

Why?

The company board agreed to pay Sharer more than most chief executives in the industry — with a compensation "value closer to the 75th percentile of the peer group," according to a 2011 regulatory filing.

This is how it's done in corporate America. At Amgen and at the vast majority of large U.S. companies, boards aim to pay their executives at levels equal to or above the median for executives at similar companies.

The idea behind setting executive pay this way, known as "peer benchmarking," is to keep talented bosses from leaving.

But the practice has long been controversial because, as critics have pointed out, if every company tries to keep up with or exceed the median pay for executives, executive compensation will spiral upward, regardless of performance. Few if any corporate boards consider their executive teams to be below average, so the result has become known as the "Lake Wobegon" effect.

It wasn't until recently, however, that its pervasiveness and impact on executive pay became clear. Companies have long hidden the way they set executive pay, but in late 2006, the Securities and Exchange Commission began compelling companies to disclose the specifics of how they use peer groups to determine executive pay.

Since then, researchers have found that about 90 percent of major U.S. companies expressly set their executive-pay targets at or above the median of their peer group. This creates just the kinds of circumstances that drive pay upward.

Moreover, the jump in pay because of peer benchmarking is significant.

A chief executive's pay is more influenced by what his or her "peers" earn than by the company's recent performance for shareholders, according to two independent research efforts based on the new disclosures.

One was by Michael Faulkender at the University of Maryland and Jun Yang, of Indiana University, and another was led by John Bizjak at Texas Christian University.

"Peer benchmarking has a significant influence on CEO pay," Bizjak said. "Basically, you can't have every CEO paid above average without pay ratcheting upward over time."

The gap between what workers and top executives make helps explain why income inequality in the United States is reaching levels unseen since the Great Depression.

Since the 1970s, median pay for executives at the nation's largest companies has more than quadrupled, even after adjusting for inflation, according to researchers. Over the same period, pay for a typical nonsupervisory worker has dropped more than 10 percent, according to Bureau of Labor Statistics.

Even before the extent of the peer benchmarking was known, it drew criticism from prominent business figures.

After the Enron scandals, a blue-ribbon committee led by Peter Peterson, then chairman of the Federal Reserve Bank of New York, and John Snow, former chairman of the Business Roundtable, called for setting executive pay "unconstrained by median compensation statistics."

Legendary investor Warren Buffett, in one of his famously plain-spoken letters to investors, likewise derided the method.

"Outlandish 'goodies' are showered upon CEOs simply because of a corporate version of the argument we all used when children: 'But, Mom, all the other kids have one,' " he wrote.

Similarly, former Federal Reserve Chairman Paul Volcker called it the "Lake Wobegon syndrome" in congressional testimony in 2008, referring to Garrison Keillor's fictional town where "all the children are above average."

Amgen selected 11 companies in the biotech/pharmaceutical field, which seems natural enough. But most of the companies on the list are far larger than Amgen. Amgen's revenue in 2010 was $15 billion; the median revenue of its peer companies was $40 billion, according to Equilar.

Maybe even more significantly, however, the Amgen compensation committee also decided that Sharer, despite being at a smaller company, should earn stock compensation at the 75th percentile of peers.

This is critical because stock compensation tends to be the largest component of executive pay.

The company has said that stock compensation serves as a good incentive; the more stock he owns, the more reason he has to try to boost the company's value.

Moreover, the company says, to receive the $21 million in reported compensation, Sharer must reach an array of goals with the company, so much of his pay is "at risk."

The practice has persisted because corporate board members, many of whom have personal or business relationships with the chief executive, have been unwilling to abandon the practice.

At Amgen, for example, four of the six members of the board compensation committee had personal or business connections to Sharer before joining the board. In fact, he nominated at least two of the six to the board, according to a company source and reports.

These kinds of ties — between chief executives and the boards that oversee them — permeate corporate America. On a typical board, the chief executive considers about 33 percent of the board of directors as "friends" rather than as mere "acquaintances,"according to a survey of chief executives at about 350 S&P 1500 corporations conducted over 15 years by University of Michigan business professor James Westphal.

More tellingly, the chief executive is likely to find even more friends on the compensation committees of corporate boards — almost 50 percent.

Sharer declined interview requests, and members of the board's compensation committee did not return phone calls seeking comment for this story.

Sharer has done well. He owns at least three homes, according to property records: a $2 million home in Los Angeles, a $6 million spread in Vail, Colo., and a $5 million place on Nantucket.

Representatives of the compensation consultant Frederic W. Cook & Co., which provided the analysis that led to Sharer's raise, also declined to comment. A reporter who visited Amgen's Thousand Oaks headquarters was prevented from meeting with the company's spokeswoman.

Amgen released this statement via email:

"Our executive-compensation programs are oriented toward rewarding long-term performance in support of stockholders' interests and are designed to attract, motivate and retain the highest level of executive talent by paying them competitively, consistent with their roles and responsibilities, our success and their contributions to this success."

In an advisory vote by Amgen shareholders in May, about 56 percent of votes cast approved the company's executive compensation. Many shareholders, however, are frustrated.

"The members of the Amgen board are basically just rubber-stampers," said Steve Silverman, who owns one of the largest chunks of Amgen stock held by an individual investor. "Kevin put most of them on the board himself. If he's getting paid too much — and he certainly is — they're not going to say so."

Moreover, the effects of his raises are not limited to Amgen.

In fact, because of peer benchmarking, raises at one company have ripple effects across corporate America: Thirty-seven other companies name Amgen as a "peer," including Wal-Mart, MasterCard and Time-Warner, as well as other drug companies, according to Equilar.

Next year, at those companies that use Amgen as a peer, Sharer's new compensation package will be used as a benchmark, propelling executive pay upward.

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