Bill Smith and Lani Guloy are members of the Northwest Comensation Consulting Practice of Watson Wyatt Worldwide (watsonwyatt.com), an international HR consulting firm. Their office is located in Seattle.

Every year, in the late summer or early fall, lists such as Oregon Business's 50 top-paid CEOs appear all over the country. These lists detail the compensation paid to CEOs who are charged with overseeing the investments and career interests of thousands of stakeholders in publicly traded companies, and of course it's there's keen interest in knowing who tops the charts in any given year.

However, it is important to keep in mind that the annual pay reported for any CEO can vary significantly depending upon the methodology used to value elements of executive compensation, particularly long-term incentives. Different methodologies produce different "winners."

This year's list in Oregon Business uses a different approach from past years regarding long-term incentive compensation, reflecting an upcoming change in accounting rules for stock options. The most prevalent form of long-term incentive, stock options allow executives to control the timing of payouts. Hence, what occurs with these awards in any one year may or may not appropriately be attributed to that year. As a result, there are a variety of ways to rank compensation. Following are three common approaches, each of which produces a significantly different result (in this year's list, we have utilized the third option — total intrinsic direct compensation — as described below).

1. Total cash compensation
In previous years, we ranked CEOs by their total cash compensation (salary and annual bonus) and then highlighted information on the size of new long-term incentive awards and the values actually realized during the year from previously granted long-term incentive awards.

Had we stayed with this approach, Phil Knight, who headed Nike during the 2004 proxy year, would have led the list with total cash compensation of nearly $3.8 million. Mark Donegan from Precision Castparts Corp. would have been ranked No. 2 at nearly $2.1 million. The drawback to this approach is that it does not directly consider the value of long-term incentive awards which can exceed the value of a CEO's total cash compensation.

As an indication of a stronger economy, total cash compensation for the top 50 CEOs increased by 17.7 % year-over-year. Salaries were up 5.3%, while bonuses increased by a whopping 34.8%.

2. Total realized direct compensation
To remedy the problems associated with the first approach — total cash compensation —we could add to salary and bonus the actual value of previous long-term incentive awards realized during the year, to arrive at a figure for total realized direct compensation. Under this approach, gains from options exercised, actual payouts received from other long-term incentive plans, and the face value of restricted stock awards would be counted.

If we had employed this approach, the top slot would be held by Earl Lewis of FLIR Systems, with total realized direct compensation of nearly $13.8 million. Of this, approximately $12.4 million resulted from the exercise of stock options. Phil Knight, on the other hand, would have dropped to No. 4.

Total realized direct compensation for the top 50 CEOs as a group increased by 52.4% from 2003. This significant change was driven not only by solid salary increases and substantially higher bonuses but also by a dramatic increase of 123% in realized gains from long-term incentives.

The problem with this approach is that long-term incentive values realized during any given year almost always have been earned over several years. A CEO in a successful company may elect to exercise no stock options for several years before making the decision to exercise them at one time. As an example, FLIR's Earl Lewis did not exercise any options in the previous proxy year, when his total realized direct compensation was less than $1 million. To get a more realistic picture of the annualized long-term incentive values, compensation professionals frequently average realized gains over several years.

3. Total intrinsic direct compensation
This year, we have ranked the CEOs based upon total intrinsic direct compensation — salary, annual bonus, plus the intrinsic value of new long-term incentive awards made during the year. This represents the incentive award's estimated value on the day it was granted.

Using this approach, Mark Donegan from Precision Castparts leads the list with total intrinsic direct compensation of approximately $9.1 million. Of this, more than $6 million is attributable to the intrinsic value assigned to 200,000 stock options granted during the year. Nicholas Konidaris from Electro Scientific Industries is a close second at just over $9.0 million, with nearly $8.5 million attributable to 420,000 stock options.

We do not have last year's intrinsic values, however, it is worth noting that the number of stock options for the top 50 CEOs as a group dropped from 4.6 million last year to 3.3 million this year. This is consistent with national trends that show more companies offsetting at least a portion of historical stock option awards with restricted stock and/or performance achievement awards.

The intrinsic approach is fast becoming the standard for valuing long-term incentive awards. A primary contributor to this trend is new Financial Accounting Standards Board (FASB) rules that, beginning in 2006, require stock options to be expensed on corporate income statements. The amount to be expensed must be determined at the time a stock option award is made. To comply, companies must determine an intrinsic value for each award.

The most prevalent tool used to establish a stock option's intrinsic value is the Black-Scholes pricing model, originally developed in the early 1970s by Fisher Black, along with Nobel economists Myron Scholes and Robert Merton, to value market-tradable options. For valuing employee options, there are six standard inputs: current stock price, exercise price, option term, risk-free interest rate, dividend yield and volatility.

New accounting rules provide some guidance on determining inputs for Black-Scholes and other valuation models, but FASB does not dictate any one specific method. So companies must rely on historical data and judgment to justify input assumptions. As a result, public companies are scrambling to determine defensible assumptions to avoid over-expensing.

Modest changes to the assumptions can create substantial changes in the intrinsic value assigned to an award. For example, if we assume a 3% risk-free rate of return, no dividends, an eight-year term and volatility of 0.6, a stock option award's intrinsic value would equal approximately 65% of the options face value at the time of award. An option on $10,000 of stock would have an intrinsic value of $6,500.

If we lower the assumed term to six years and reduce the volatility assumption to 0.4, the intrinsic value would equal approximately 43% of face value. An option on $10,000 of stock would have an intrinsic value of $4,300.

Firms such as Watson Wyatt have developed more sophisticated derivative models that allow for a more detailed breakdown of assumptions based upon actual past and implied future trends and behaviors.

We have based our estimates of intrinsic value for Oregon's Top 50 Highest Paid CEOs on each company's three-year daily volatility, the full option term, the U.S. government bond yield over the term and dividends for the 12 months prior to option grant.

Another factor contributing to the use of intrinsic values is the added emphasis being placed on Board Compensation Committee prudence which has also increased the pressure on Boards to establish a consistent methodology for defining compensation values for CEOs and other executives. Determining an intrinsic value at the time of award facilitates comparing stock option awards with other long-term incentive values and enables all elements of compensation for any given year to be conveniently "tallied" for comparison with other relevant organizations.

While this approach is becoming the preferred method for defining the value of executive pay packages, it is far from perfect. Short of a miracle, the intrinsic value assigned to stock options will never be the same as the value the recipient actually realizes. The realized value of any option award ultimately depends on the amount of stock price appreciation at the time the option is exercised which generally does not occur until five to ten years after an award is made.

Because the expense associated with a stock option is "fixed" at the time of award, stock options have garnered most of the attention in the debate over the appropriateness of using intrinsic value. However, for purposes of comparing compensation with competitors and determining the size of awards for CEOs and other executives, the question of the intrinsic value is also an issue that can affect the way we consider other long-term incentive awards.

In determining this year's Oregon's Top 50 Highest Paid CEOs, we had to make decisions relative to the value of other types of long-term incentive awards including the following:

Restricted Stock / Restricted Stock Unit Awards that normally constitute outright grants of a predefined number of shares of stock at the end of a certain employment timeframe, often three years. In some cases, performance hurdles may also be attached. We elected to include the full face value of these as compensation in the year they are granted. Some people argue that, since these awards are subject to forfeiture and won't be paid until a future date, their intrinsic value should include a discount of as much as 10% to 12% of face value. Others argue that expected inflationary price movements in the stock eliminate the need for any discount.

Performance Achievement Long-Term Incentive Plans (LTIPs) that are payable in cash and/or stock at the end of a three- to four-year performance period. These plans normally involve annual overlapping awards. Each of award has a target value expressed as a percentage of salary representing the amount that is payable if predetermined goals are met. Awards generally can exceed target for outstanding performance and are most often subject to threshold goals below which no values are payable. In determining compensation values for Oregon's Top 50 Highest Paid CEOs, we reflect target LTIP values for awards made during the last proxy year. It could be argued that these awards should also be discounted for the same reasons as restricted stock.

It is impossible to determine if the target value is a reasonable measure of the intrinsic value without being able to effectively evaluate the reasonableness of the goals that must be met for payouts to occur.

To get an additional insight into the validity of intrinsic value calculations, Watson Wyatt recently surveyed 1,000 high-income employees from a cross-section of companies, asking them what they believed 500 stock options and 100 shares of restricted stock at their company was worth to them. Depending on the industry and the circumstances of different companies, the perceived value of stock options ranged from 50% to 70% of the intrinsic value as calculated using the Black-Scholes model. The perceived value of restricted stock ranged from 80% to 90% of the face value.

Unfortunately, due to the important role of long-term incentive programs that reward CEOs for sustained performance over time and often allow them to control the timing of payouts it is difficult to compare total compensation earned in any one year. Intrinsic value calculations at the time the long-term incentive awards were made can provide useful insights but, ultimately, will differ from values actually realized. Compensation Committees should understand that all of these value observations are just reference points to assist them in making informed judgments on CEO pay.

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Copyright 2005 Oregon Business magazine