Cozy relationships and ‘peer benchmarking’ send CEOs’ pay soaring

As the board of Amgen convened at the company’s headquarters in March, chief executive Kevin W. 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 hid 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.”

‘All the other kids have one’

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 non-supervisory worker has dropped more than 10 percent, according to Bureau of Labor statistics.

Critical to executive pay levels is peer benchmarking.

Even before the extent of the practice was known, it drew criticism from prominent business figures. After the Enron scandals, a blue-ribbon committee led by Peter G. 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.”

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 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.

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.”

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

“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.”

Skewing the comparisons

To examine the process of peer benchmarking for executives, The Post chose to examine the case of Amgen, but the practice is widespread and yields controversial results at many companies:

• At Adobe Systems, the software company, 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 M. 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.

“I strongly believe that a decade from now there will be a recognition that entre­pre­neur­ship has been driven out of the public sector,” he wrote in an October 2006 e-mail that was turned up by a congressional investigation.

Performance questioned

Known for his ambition and a blustery manner, Sharer, a 1970 graduate of the Naval Academy, arrived at Amgen in 1992 as president, chief operating officer and a member of the board of directors.

Amgen had been a high-flying firm. Founded in 1980, it had rapidly become one of the largest biotech companies in the nation, thanks to its success with two drugs, Epogen, for people suffering kidney disease, and Neupogen, a drug used in cancer treatment.

Sharer, whose executive career included stints at MCI, General Electric and the McKinsey consulting firm, believed in the importance of his position.

“Leadership has been the most important force in the history of the world, and it is clearly the most important quality in running companies,” Sharer told Harvard Business School students in 2001.

He would soon make what may have been his most significant move at Amgen. In December 2001, he struck a deal to acquire Immunex, a company with a blockbuster rheumatoid arthritis drug called Enbrel. The company had a price tag of about $17.8 billion, according to SEC filings, and some Wall Street analysts at the time thought it was a terrible mistake. Some said he’d paid double what Immunex was worth, though after Amgen’s stock dropped, the price it paid did, too.

“Amgen acted desperate at a time it did not need to be desperate,” said stock analyst Douglas Christopher. “It allowed them to say, ‘Look, we have a third product,’ but at a massive price.”

There was another bit of turbulence, too. According to the Los Angeles Times, at about the same time, Sharer had a romantic relationship with a married Amgen vice president. “Senior executives” tried to persuade him to end the relationship, but he didn’t until the employee left the company in 2001, according to the newspaper.

The company continued to grow during Sharer’s early tenure, and more recently, the company has boasted greater earnings per share. But by 2006, the growth that once distinguished Amgen had begun to taper off.

In 2008, Forbes magazine named him among among the country’s most overpaid bosses because the company’s returns had dipped 4 percent annually over six years while he’d earned an average of $12.3 million.

The lack of enthusiasm was even more noticeable among the people who know most about Amgen — insiders. Companies are required to report when their officials sell stock. Since 2002, the ratio of share sales to purchases has been 12 to 1, according to Bloomberg data reviewed last fall by Christopher.

Under peer benchmarking, however, even when shareholders lose, executives can win.

Bias can creep into the process in several ways. At Amgen, it began with the choosing of “peers.”

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.

The practice of choosing peers that boost pay is common. Studies by Faulkender, Bizjak and ISS Corporate Services have shown that when choosing “peers” for pay-setting purposes, companies tend to choose larger firms or firms with more highly paid chief executives.

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.”

But how much is his pay really in doubt? Most of the stock compensation Sharer is slated to receive as a long-term incentive is contingent not on the company’s financial performance but simply on whether Sharer remains at the company, ISS Proxy Advisory Services has pointed out. Moreover, the reported compensation figure of $21 million is based on the company’s projections of “probable” financial outcomes.

As a result, Sharer has earned raises while shareholders have lost money. In 2010, Amgen’s shareholder return was minus 3 percent. In 2009, shareholder return was minus 2 percent.

In both years, Sharer received significant pay increases, even though Amgen’s “peer” companies made gains for shareholders, according to Equilar.

“He’s basically done nothing for the company,” Silverman said. “And he still gets raises.”

Sharer has tried to cut costs, however, pushing out workers at plants around the country: at its headquarters in Thousand Oaks, in West Greenwich, R.I., and Longmont, Colo.

Outside the Longmont plant recently, where more than 90 workers were laid off in June, a pair of contract workers said they’d been hired to replace dismissed workers.

“We’re cheaper,” one explained. “Honestly, I’m just glad to have a job.”

Former employees were reluctant to talk about Amgen because, they said, their severance pay could be affected. But some were “furious” about what Sharer was earning.

“Obviously,” said one woman who used to work at the Thousand Oaks facility, “only some people matter.”

Sharer, meanwhile, 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.

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.

Staff researcher Lucy Shackelford contributed to this report.

Peter Whoriskey is a staff writer for The Washington Post handling investigations of financial and economic topics. You can email him at peter.whoriskey@washpost.com.
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