The real outrage is how CEOs are paid, not how much

Interview by Geoff Colvin, senior editor at large

(Fortune) -- It's outrage season, formerly known as proxy season, when recession-shocked Americans get furious at the new list of insanely overpaid CEOs. The leader so far is Occidental Petroleum chief Ray Irani ($59 million), an excessive-pay hall-of-famer, but he may be overtaken by others as more proxies are filed.

The bad-boy headlines will misleadingly suggest that CEO pay levels overall are a problem. They're not. For hundreds of big-company CEOs, pay came down in the 2001 recession, rose in the expansion, and has come down again in this recession, just as you'd hope, according to research by the University of Chicago's Steven Kaplan.

The inflation-adjusted average is lower than in 1998, at just over $11 million. That's nothing to sneeze at, of course, but the real problem is the way in which CEOs are paid -- the incentives they're given. Despite new SEC disclosure rules and the painful recession, by some measures the situation is getting worse.

If you want to get mad at companies for screwing up executive pay, here are three good reasons:

They're incentivizing managers to do stupid things

A large majority of companies base their long-term and short-term incentive payouts -- which often form the bulk of executive comp -- on the company's reported income, earnings per share, total shareholder return, and various other ratios, according to a new analysis by the James F. Reda compensation consulting firm. Sounds sensible, but it isn't.

Research has long shown that reported earnings and EPS correlate poorly with what shareholders actually care about -- the value of their company. In addition, earnings, EPS, and return ratios are easy for managers to manipulate through all kinds of arbitrary decisions about reserves, write-offs, taxes, pension assumptions, and other factors. Even total shareholder return can be gamed by paying out a big dividend, potentially destroying value.

Much better to incentivize managers with an economic profit target (operating profit minus a capital charge), as Best Buy (BBY, Fortune 500), Deere (DE, Fortune 500), and many other top performers do. Research shows it correlates far better with stock value, and as Best Buy chairman Richard Schulze says, it "focuses management to think like shareholders."

They're paying based on irrelevant comparisons.

Among the 200 biggest U.S. companies, 53% based their long-term incentives on comparisons with a peer group or index in last year's proxies, up from 44% the year before, according to Reda's analysis.

But shareholders don't care how well a company performed relative to its industry; they care whether the company was a good place to park their capital. When managers focus on beating their industry peers, they forget that investors can put their money anywhere. Executives shouldn't be rewarded for performing a little less poorly than average in a lousy industry, because it does investors no good at all.

If they're in a lousy industry, they should get out.

They're not always telling us their real goals.

SEC rules that took effect in the 2008 proxy season require companies to disclose the targets that executives must hit in order to earn incentives -- the percentage increase in profits, for example, or the specific return on invested capital -- and then report the company's performance vs. those targets.

Yet many companies just aren't doing it, claiming they'd be giving away competitive information (the SEC sometimes grants exceptions on that basis).

For example, the 2009 CVS Caremark (CVS, Fortune 500) proxy statement doesn't disclose the company's three-year EPS growth target for the period ending in 2010 because that "would result in competitive harm to the Company." Reda raises a more disturbing possibility for some nondisclosures: Companies may be offering their executives incentives for performance below publicly announced profit forecasts.

As outrage season progresses, we'll hear plenty about this year's crop of egregiously overpaid CEOs. Let's just remember that far more hazardous to shareholders is the irrationally paid CEO.  To top of page