May 20, 2003

Sean Harrigan
President, CalPERS Board of Administration

Mr. Chairman, before I begin my formal statement I would like to express my appreciation to Senator Boxer for her kind introduction. I am deeply gratified by her presence and her interest in the subject matter before the committee today.

Mr. Chairman, Senator Hollings and members of the Committee, it is my pleasure to be here today and to provide the perspective of an institutional investor in regards to executive compensation. I also have some suggestions where Congress could take action to help support reform in executive compensation.

I am Sean Harrigan, President of the California Public Employees' Retirement System (CalPERS) Board of Administration. CalPERS is the largest public pension system in the U.S., with approximately $125 billion in assets. We have long been a leading voice in Corporate Governance, and an advocate for better alignment of interests between shareholders and management.

Executive compensation is a critical issue to investors. Compensation is a truly powerful tool that will drive behavior. Unfortunately, it can drive the wrong behavior if the proper checks and balances are not in place, or if the compensation schemes are just poorly constructed. CalPERS and I believe most investors are not anti-compensation. In fact, we believe paying competitive salaries for managerial talent is an important motivational tool. But, we feel strongly that pay should be linked to long-term sustainable performance in a very significant manner.

Something has gone wrong with executive compensation in the United States. It is unconscionable to see that CEO pay has swollen to 400 times that of the average production worker. It is shocking to see example after example of top executives insulating themselves from any risk in their own compensation, and ensuring their own financial security at the same time employees are being asked to shoulder the burden of cuts, and shareholders are losing value.

At American Airlines shareholders and employees were shocked to find out that the company made a $41 million dollar payment to a fund designed to protect the pensions of executives if the company filed bankruptcy. This fact was not disclosed during negotiations to secure $1.8 billion in wage concessions despite the fact that the payment was made months before.

If I had to identify one issue that is at the heart of the problem with compensation in the United States, I would point to accountability. More appropriately perhaps to a lack of accountability. This is an area where we can make reform with the support of Congress.

As public markets investors we rely upon boards of directors to represent us. In the case of compensation, the Compensation Committee is charged with representing shareholders. It is clear to me that a major contributing factor to the problem with executive compensation is that Compensation Committees are not accountable to shareholders. They obviously do not feel that approving abusive compensation packages will cost them their job. Rather, it appears that not approving what the CEO wants is what they feel will cost them their job. This represents the central conflict of interest inherent in the problem of executive compensation today. Until this fundamental issue is solved, we will continue to have widespread abuse in compensation practices.

In the last five years alone, CEO compensation has doubled according to compensation consultants Pearl Meyer & Partners. In 1996, the average CEO at the largest 200 companies made about $5.8 million. By 2001, that figure jumped to $11.7 million.

The following table compares the trends in specific components of CEO pay to the performance of the S&P 500 for 2001 and 2002.

We think this shows a disconnect between compensation and performance on a broad scale. Part of our concern is that it appears companies shifted compensation from cash to options in 2001, then from options to cash in 2002 - most likely due to the bear market. It is also important to note that the value of the option grants declined at least in part due to lower overall stock prices. It appears that a similar number of options are still being granted (median number of options declined only 9 percent in 2002). This was the only factor driving the median total compensation down in 2002.

However, while the absolute levels of pay are a concern, perhaps the most troubling element of executive compensation is the heads I win, tails you lose attitude of corporate executives. CalPERS is deeply concerned over what appears to be an attitude of entitlement in the executive suite of corporate America. This attitude manifests itself in many forms.

Perhaps some of the more offensive entitlements are the so called forms of "stealth compensation." Lavish severance packages complete with perks for life that are fit for a king, guaranteed pension benefits far outstripping the value of benefits provided to employees, enormous loans to executives that are eventually forgiven, and provisions providing that the company shall pay all the taxes due (including gross-up provisions) should the executive incur a tax liability all send a clear message to shareowners. The message is that we do not respect you as owners, and we do not feel accountable to you as owners.

In other examples demonstrating a lack of respect for shareholder's capital:

Delta Airlines, Leo Mullin will be credited with 22 years of service toward his pension upon termination, plus two additional years in a Supplemental Retirement Benefit. The company also put $25.5 million in a protected pension trust for him according to press accounts.

Home Depot has an employment contract that includes a $10 million loan with predetermined criteria for forgiveness in addition to base salary, 2,500,000 stock options (plus annual increments of no less than 450,000 more options), a target bonus of between $3,000,000 and $4,000,000, deferred stock units (750,000 in 2002), pension benefits and change in control provisions that include (if the executive leaves for good reason or for any reason within 12 months) $20,000,000, immediate vesting of options, and immediate forgiveness of any outstanding loans and payment of the gross-up for taxes.

We do however feel that there are concrete steps that can be taken to help reign in abusive executive compensation. Shareholders must take a more active role overseeing directors at the companies in which we invest with the goal of increasing the absolute level of accountability of directors to shareholders must be increased. There are also several improvements to the structure of compensation programs that we believe can have a dramatic effect on rationalizing executive pay. Let me briefly go over the steps CalPERS is taking in the area of executive compensation and mention some of the specific proposals we have made to improve the alignment of interests.

Executive Compensation Policies

CalPERS amended its U.S. Corporate Governance Core Principles and Guidelines recently to call on companies to formulate executive compensation policies and seek shareholder approval for those policies. Currently, Compensation Committees issue a statement in the proxy to briefly describe the company's compensation philosophy. Shareholders role in this process is relegated to a distant back seat. In discussions with companies about this issue, they often state emphatically that only the board has the right and the expertise to manage the affairs of the company and particularly the issue of compensation. Companies state that the Compensation Committee must have the flexibility to attract and retain executives and that shareholders should essentially trust them to do the right thing. Yet the behavior of corporate America in regards to executive compensation indicates otherwise.

We believe it is a completely appropriate role for owners of a corporation to approve broad policies in relation to executive compensation. Perhaps most importantly, it would force Compensation Committees to face shareholders with a plan on how they will use compensation of all forms in managing the corporation. This will help to shift the accountability back to where it belongs, to the owners.

Action item 1: Congress could support these recommendations and call upon the SEC and the exchanges to consider requirements that shareholder approve executive compensation policies.

We believe that executive compensation policies should provide the following, at a minimum:

The company's desired mix of base, bonus and long-term incentive compensation;

The company's intended forms of incentive and bonus compensation including what types of measures will be used to drive incentive compensation. Again, we believe companies should construct incentive plans with a significant portion of performance based components;

The parameters by which the company will use severance packages, if at all.

Quantitative Model - Website Application as a Research Reference Tool

CalPERS is also dedicating a portion of its website to executive compensation issues. In the near future we will post a catalog of extensive research available in the executive compensation arena. We are also developing a quantitative model that we will apply to our U.S. indexed holdings to help identify on a more systematic basis where compensation abuses are occurring. The model will be used to identify companies where performance and compensation diverge by analyzing peer relative and market relative compensation measures along with performance data. It is our intent to use our website to highlight cases of egregious compensation much in the way we have used public means in our Focus List of under-performing companies.

Greater Performance Based Metrics

In another major effort, we are pushing for greater use of performance based metrics in equity compensation plans. Standard at-the-money fixed price options - those with the strike price set at the current market value of the stock on the day of the grant - have been used extensively in the United States, and have become the largest single component of CEO pay. While fixed price options do have some merit as an alignment tool, they are inferior in many ways to performance based plans. Yet companies have been reluctant to say the least to adopt performance based equity plans. CalPERS recently co-sponsored a shareholder proposal at General Electric calling for the company to make a significant portion of their option grants to top executives performance based. The company adamantly opposed the resolution, they said because not many companies are using these types of equity grants. One can only suspect that it was really because they do not want to be held to true measures of outperformance to obtain the highest levels of incentive compensation. It is easy to see why shareholders and management differ on these issues.

Shareholder Approval of Equity Based Compensation

CalPERS is also lobbying hard to help ensure that shareholders have the right to approve any equity based compensation plan. Under current exchange rules, companies are not required in certain circumstances to obtain shareholder approval to adopt equity-based compensation plans. In other words, companies are allowed to unilaterally dilute the equity owners of the corporation. It is ridiculous to think that an owner should not have the right to decide if he or she is willing to dilute their equity, no matter what the purpose. It is even more ironic when you consider the fact that boards and management have a significant self interest in adopting equity based compensation plans.

While shareholders have fought the NYSE and NASDAQ for years over this issue, it has finally come to pass that the proposed changes to the listing standards include greater shareholder approval of equity based compensation plans. But the fight is not over. Despite the fact that the proposed changes to the listing standards were developed last summer, the SEC has yet to implement this change. Most troubling of all, the exchanges are seeking a number of exceptions to shareholder approval that would continue to let companies unilaterally dilute equity owners. We are opposed to these exceptions. We believe this can be the shortest rule the SEC will ever be able to issue, and it can be stated in a single sentence: Any new equity based compensation plan or material change to an existing plan must be shareholder approved.

Action item 2: Congress could join shareholders in supporting shareholder approval of all equity-based compensation plans without exception.

Shareholder Access to the Proxy

And finally I would like to mention one remaining reform we are advocating, shareholder access to the proxy. This would provide that shareholders who meet minimum ownership thresholds could nominate directors to corporate boards through management's proxy. While this may not appear to be particularly relevant to executive compensation at first glance, it has everything to do with accountability. With responsible yet meaningful reforms to the SEC rules governing access to the proxy, shareholders will be given greater ability to hold directors accountable for poor performance. As I mentioned earlier, we believe this has a material impact on their behavior and on the quality of their representation of shareholder's interests. This has an obvious impact on our ability to right the ship when it comes to compensation.

Action item 3: Congress could join shareholders in seeking fair access to the proxy.

Thank you, I would be glad to answer any questions that you may have.