In 2006, the top 50 highest-paid public company CEOs in Washington saw a 6.4 percent increase in their average total compensation. On average, total CEO compensation was $3,840,887, up $230,002 from 2005. Of the $230,002 gain, higher bonus payouts accounted for 31 percent of the increase, with larger long-term incentive (LTI) grants accounting for 59 percent of the increase. The average base salary increased by a relatively small amount. The increase in variable incentives compared with fixed base salaries indicates a general movement toward pay for performance.

In 2006, there were increases in the averages of all broad categories of total compensation:

• Base salaries up $2,979 (0.6 percent)
• Bonuses, up $70,370 (11.3 percent)
• LTIs up $136,481 (5.8 percent)
• Other cash compensation up $20,171 (24.3 percent)

The composition of long-term incentive equity grants changed significantly in 2006. Companies continue to shift away from the use of stock options, and have moved to utilizing performance shares, restricted stock and cash-based LTI programs instead. Stock options continue to represent over half of the value granted in equity-based programs. Both restricted stock and performance shares displayed gains of 5 percent to 6 percent, respectively.

The highest-paid CEO in 2006 was Kerry Killinger of Washington Mutual Inc. His total compensation of $18.1 million included restricted stock, performance shares and option awards totaling roughly $12.5 million. Killinger topped the list for the second year in a row.

New disclosure requirements were the biggest news in executive compensation. Due to public outcry over the past five years, the Securities and Exchange Commission recently changed the proxy reporting requirements. Of the top 50 CEO-compensating companies in Washington, 40 had fiscal year-ends after December 15, 2006, and thus used the new proxy format. Our methodology for calculating total compensation for ranking purposes did not change as a result of the new disclosure rules.

The only impact the new disclosure rules had on our calculations is that the FAS123R value at grant of options was explicitly reported this year. For the five companies that granted stock options and did not file under the new disclosure rules, we continued to estimate a Black-Scholes ratio using assumptions reported in the companies? annual report footnotes.

We continue to rank CEOs by summing the following components:

• Base salary
• Actual bonus earned
• Value associated with the opportunity of earning a long-term incentive
• All other compensation (except pension- and deferred compensation-related values).

The new disclosure requirements are intended to help investors evaluate the link between executive pay and company performance. In the Compensation Discussion and Analysis (CD&A) section of a company?s proxy statement, the company must now discuss the measures of performance, the degree of difficulty in attaining these measures, and the rationale for payment. In the required executive compensation tables, each company must provide the minimum, target and maximum award opportunity for both short-term and long-term incentives. A total of 27 companies reported target bonuses, with a median target (as a percentage of base salary) of 85 percent.

These new reporting requirements enable investors to compare the actual bonus earned for the year with what the CEOs were targeted to receive for expected performance.

For 26 companies, information was provided that allowed us to calculate a bonus achievement rate (actual bonus amount divided by target bonus amount). Investors are better able to assess the link between pay and performance by comparing the company?s bonus achievement rate against its total return to shareholders for the year. The graph below illustrates the relationship between bonus achievement rate and total shareholder return for the company?s fiscal year.

We expected CEOs who earned more than the target award opportunity to have a positive total shareholder return for the fiscal year. This was indeed the case for most of the 26 companies in the chart. By this measure, pay for performance appears to be alive and well with Washington CEOs.

It is worth noting some other new information required in the proxy disclosures. For various reasons, these components are not included in our ranking calculation, but they do provide valuable insight into the value delivered to CEOs in Washington.

Pensions. Under the new reporting requirements, each company must provide an actuarial estimate of the current value of all defined benefit pension programs. This disclosure must include both qualified plans, in which all employees participate, and nonqualified plans, in which only selected employees may participate. The change in value from year to year in these programs is reported in the summary compensation table as an estimate of what they ?earned? from their pension program. However, this amount is not included in our ranking calculation due to the various uncontrollable events (such as age, years of service and other assumptions used for the calculation) that may trigger a substantial increase or decrease in the value of the pension from year to year.

Deferred Compensation. Although the Summary Compensation Table must now include any above-market interest earned on deferred compensation, this amount is likewise not included in the ranking calculation. The companies also must report contributions and ending balances for deferred compensation for each executive in a separate table. These balances may be very large for long-tenured executives, and should be viewed not only as tax-sheltered savings for the executive, but also as a loan to the company from the executive.

Termination Scenarios. To inform investors of any potential compensation that an executive may receive in the future under existing agreements, the company must disclose payment under all possible termination scenarios. Companies were required to discuss termination scenarios in a narrative format, but many chose to provide this information in a tabular format. Executives often receive payments if they leave the company for various reasons, including voluntary termination, involuntary termination without cause, change in control, death and disability. This disclosure allows an investor to determine if there are any ?golden parachute? arrangements and the values associated with the arrangements upon termination.

The new disclosure rules have required companies to provide the data necessary for an investor to analyze executive pay from both a competitive perspective and an alignment-with-performance perspective. The greatest challenge is synthesizing and interpreting the data to form meaningful conclusions.

Linda Steffen and Bill Smith are members of the Northwest Compensation Consulting Practice of Watson Wyatt Worldwide, a leading global human resource consulting firm.