AS the state's economy continues to rally in multiple sectors, CEOs aren't doing too bad either. In 2005, CEOs in Washington saw a 23.7 percent increase in their total compensation, receiving on average $3,616,885 in total compensation, up $692,222 from 2004, according to Watson Wyatt Worldwide, a global human resource consulting firm.

Base salaries averaged $534,368, a $22,498 (4.4 percent) increase over 2004, while the average bonus increased by $55,143 (9.7 percent) to $624,679. The mean value of stock option awards was $1,453,325, up $44,250 (3.1 percent) from 2004. Other cash compensation went up by $7,988 (10.7 percent) to $82,761 per executive in 2005. How CEOs got there changed slightly from 2004 to 2005.

Stock options were increasingly scarce, comprising only 63.7 percent of all equity instruments used in 2005, as compared to 79.0 percent in 2004. There was increased use of restricted stock, with this vehicle making up 24 percent of the equity given out in 2005, up from 13.7 percent in the previous year.

MEASURING METHODS

The values reported reflect specific decisions about how to value the elements involved in executive compensation programs. Every year various national, regional and local business publications attempt to create rankings of CEO pay within a given demographic: national, regional or local. Unfortunately, because of ambiguous and imprecise Securities and Exchange Commission (SEC) disclosure rules, there has been no common methodology for creating these rankings.

Let us assume that we have two publications that are trying to create lists ranking CEO compensation within a given state. Both publications have access to the same proxy reports for all companies that fall within the given region, and they use the same criteria to rank the executives. In the end, these two publications will most likely come to different conclusions, all because of ambiguous disclosure and valuation rules.

A common problem that arises when compiling total compensation figures is that of valuing equity instruments. While some CEO lists opt to simply rank executive compensation by â??total cashâ?? (equal to base salary plus bonus), the majority of publications attempt to assign a dollar value to equity grants. There is much confusion surrounding the valuation of equity grants, as the assumptions used to calculate equity value can vary significantly among publications.

Further blurring the CEO compensation picture is the fact that there are other forms of executive compensation that are not disclosed within a proxy statement. Under the current disclosure rules, it is nearly impossible to decipher what an executive is truly receiving, because of value being delivered through retirement programs, perquisites under $50,000. Earnings on deferred compensation are not required to be revealed.

SEC SETS CHANGES

Last January, the SEC addressed the issue of CEO compensation by drafting a new set of rules that would change disclosure requirements in order to allow for better visibility or, as SEC chairman Christopher Cox says, to create disclosures â??that can be understood by a lay reader without benefit of specialized expertise or the need for an advanced degree.â?? The SEC intends these rules to go into effect for the 2007 proxy season, affecting proxy statements covering fiscal years ending on or after Dec. 31, 2006.

The rules call for a revamped Summary Compensation Table in order to capture all the pieces of executive compensation. This revised table will include:

    * Base salary
    * Bonus earned during the period
    * Estimated value of full-value stock
      grants (restricted stock and performance
      shares)
    * Estimated value of stock options granted
    * Nonstock long-term incentive payouts
    * All other compensation

While base salary disclosure will stay the same under the rules, the period during which a bonus can be earned will change. For example, if a bonus is earned during the fiscal year but the bonus amount cannot be determined until after the proxy report has been sent out, new rules will require an additional form (Form 8-K) to be filed once that amount has been calculated. This filing will be required in order to state the bonus value, along with the amended total compensation amount.

Stock grants are slated to include any full-value grant of time-or performancevesting shares according to the new disclosure rules. Such shares will be valued by multiplying the share price at the grant date by the number of shares granted. An interesting note is that the number of years over which shares are earned and vest will not affect the value, as the full grant amount will be reported in the year of the grant.

Performance shares, which are typically tied to meeting performance goals over a three- to five-year period, will no longer be presented in the Summary Compensation Table, and the shares granted will appear solely in the year of the grant. If the rules had been in place during this year, many of the CEOs on Washington CEO's Highest-Paid Executive list would have seen a different value associated with their performance shares. For example, Washington Mutual Inc.'s CEO, Kerry Killinger, would have seen a $6.9 million increase in the disclosed value of his performance shares. Washington Mutual disclosed a value of $3,476,382 for performance shares that vested in 2005. Under the new rules, this figure would have been replaced with the estimated $10,415,990 disclosure of the target value of performance shares granted in the year.

Nordstrom Inc. CEO Blake Nordstrom would have seen the opposite effect from the SEC rule changes, had they been in place this year. While his 2005 disclosed value was estimated at $1,014,005, the new proxy rules would have changed this value to about $329,000 â?" lowering his disclosed grant value by approximately $684,000.

Under the new rules, stock options will move to a separate column of the Summary Compensation Table and will be expressed by their full accounting value at the time of the grant. As with stock grants, the option value will reflect only the estimated grant value and will not take into account the period over which the options are earned, or if any options are actually earned by the executive.

Getty Images Inc.'s CEO Jonathan Klein received an option grant on 350,000 shares, according to the Summary Compensation Table in the company's proxy statement. The new rules would require this to be reported as the total dollar value, which is $14,333,911.

A more consistent valuation of equity grants would come as a result of the revised SEC disclosure rules, thereby eliminating the subjective nature of current CEO compensation valuation. Additionally, these rules will eliminate any reporting advantage that an equity instrument had previously enjoyed.

ADDING IT ALL UP

Compensation committees, charged with making executive compensation decisions, will need to be wary of the effects of large, one-time grants of equity.

These committees must cautiously set performance criteria tied to performance shares, as grant values will be included in the total compensation calculation within the Summary Compensation Table. Such grants will be reported in the year they are awarded, regardless of whether they fail to vest (i.e., if performance goals are not met).

The â??All other compensationâ?? category will capture earnings on nonqualified deferred compensation, increases in pension value and perquisites valued at $10,000 or more.

As mentioned above, pension values will now be included in total compensation calculations and, consequently, will affect how base salary is viewed. Because any change in a CEO's base salary will exponentially influence pension value, compensation committees need to be aware of any impact a change in base salary will have on total compensation.

The new SEC methodologies for valuing executive pay are not perfect, but hopefully they will provide a consistent format for comparing and evaluating the appropriateness of total compensation levels.

Bill Smith and Linda Steffen are members of the Northwest Compensation Consulting Practice of Watson Wyatt Worldwide, a leading global human resource consulting firm. They can be reached at 206-625-1125.