January 8 2008: 5:35 AM EST

AmEx gets CEO pay right

With its new incentive plan for Ken Chenault, the card giant has created a better model for executive comp.

By Geoff Colvin, senior editor-at-large

ken_chenault.03.jpg
American Express CEO Ken Chenault

(Fortune Magazine) -- Through a rare alignment of the planets, the subject of CEO pay may get extremely hot in a few months. If it does, I'd advise four key groups - CEOs, board members, government officials, and presidential candidates - to study the remarkable grant of stock options that American Express's (AXP, Fortune 500) board recently gave CEO Ken Chenault. Members of all those groups have made stupid pay-related moves in the past, and here's a lesson in how to avoid doing so again: Chenault's new pay package is a model for how to smartly incentivise a CEO.

The planetary alignment is this: The U.S. economy will most likely be in a deep slowdown or a recession by spring, leaving Americans feeling financially insecure. At just that time, proxy season will reveal that at least a few CEOs got staggering pay despite big problems at their companies. (Remember Hank McKinnell's nearly $200 million exit package from Pfizer last year after the stock fell 40% during his tenure?) And in the midst of it all, presidential candidates will be working intensely for votes. When exactly the same circumstances combined in 1992, one result was the tax law change that makes executive salaries that are more than $1 million a year nondeductible to the company. It pleased voters but distorted pay packages and achieved nothing worthwhile.

Now AmEx's board has figured out a way to give their CEO potentially huge money while making it highly defensible and even laudable. On Nov. 30 the board gave Chenault options on 1,375,000 shares and announced its intention to give him the same number again on Jan. 31. If it all happens as planned, that will be 2,750,000 shares - a mega-grant by any definition. Chenault, of course, has an excellent record running AmEx. (He was on the cover of the Oct. 1, 2007, issue of Fortune, titled "How to Be a Great Leader.")

But the timing is intriguing. On Nov. 30 the Citigroup board was seeking a successor to Charles Prince, and you have to assume that Chenault - with no known subprime problems - was on the short list of candidates. Did AmEx's board dish up a giant option grant to keep him?

An AmEx spokesman will not say whether Chenault was offered the Citi job, only that Chenault had previously made clear he wasn't interested in it. A complex options grant like Chenault's would be almost impossible to assemble and consider on short notice; AmEx's spokesman says it resulted from three months of board discussions. Of course it might have been developed over a period of months and had some zeroes added at the last minute to keep Chenault onboard.

It doesn't matter now. What's key is the way the grant is structured. The first surprise is that it's an options grant at all. Options were all the rage in the '90s as the market roared, but lost favor after the bust. They've been replaced in CEOs' hearts by restricted stock, which is worth money even if the stock price goes nowhere. Since options are worth money only if the stock rises, a big grant is notable at a time when the market looks expensive by many measures and the economy is weak.

Even more striking are the extraordinarily high hurdles the board requires Chenault to clear if he's to get any of those options. To receive the full grant, he must beat several goals over the next six years, an unusually distant time horizon. AmEx's earnings per share must grow at least 15% a year on average, revenues must grow at least 10% a year, return on equity must average at least 36% per year, and total return to shareholders must beat the S&P 500 average by at least 2.5% a year. Chenault can receive a fraction of the grant for lesser performance, but below certain limits, which are still quite high, he gets nothing.

Now consider a couple of scenarios. Chenault misses all the targets but the market booms, returning 10% a year, and AmEx stock matches it. After their full term of ten years, his options would be in the money by $258 million - but he wouldn't get any of that. Why? Well, AmEx's stock presumably rode a rising tide, and his shareholders could have done just as well with an index fund while exposed to less risk. Alternatively, the market returns just 6% a year, in line with what many experts predict, but under Chenault's leadership AmEx hits all the targets and the stock returns 9% a year. Chenault collects a pretax gain of $222 million after a decade - an awful lot, but his shareholders are $35 billion richer than if they had chosen an index fund, and he's a hero.

In either scenario, compensation lines up with performance. That's a goal that CEOs and boards should aim for, and that politicians should vow not to hinder as they try to feel voters' pain this spring.  To top of page