(FORTUNE Magazine) – Not so long ago, a million dollars a year seemed like an absurdly extravagant income, and for nearly all the world's inhabitants, it is still the stuff of fairy tales. But in certain places in American business and finance--notably executive suites, Wall Street, and Silicon Valley--a million dollars a year today seems like...chump change.

An overstatement? Not really.

Consider that in 1997 the median CEO got total compensation of more than $3 million, according to a William M. Mercer survey. Travelers CEO Sandy Weill, who topped Mercer's charts, got an options-fueled $230.5 million. On Wall Street more than 400 Goldman Sachs bankers collected over $1 million. Only a few years ago it was unlikely that a research analyst could earn a million bucks. Yet in early August, Jack Grubman, Salomon Smith Barney's top telecommunications analyst, made headlines with his new $25 million pay package. Says John McLaughlin, a managing partner at TASA International: "In the 1980s lots of people were making lots of money. Now there's a whole stratum of people who are making astronomical sums."

Never have the numbers been so big, the rate of increase so dramatic, or the difference between the top and the bottom so extreme. Last year CEOs' total pay increased almost 30% above its 1996 level, according to the Mercer study. The New York comptroller's office says that Wall Streeters collected around $12 billion in bonuses, up 25% from 1996. (For a little perspective, consider that the average white-collar worker got a 4.2% raise last year.) Back in the 1960s the ratio of CEO pay to factory-worker pay was about 44 to one, according to the AFL-CIO; today it's over 300 to one. America's highest paid have reached the point where they think about money in a whole different way. "We're no longer talking salaries," says Lawrence Lieberman, managing director of the executive recruiter the Orion Group. "We're talking wealth creation."

It seems more like outright wealth appropriation in some notorious cases where executives have reaped great rewards in return for dubious accomplishments. A recent chiller: Al Dunlap. In early 1998, Sunbeam's board sweetened Dunlap's original contract, almost doubling his cash salary to $2 million and giving him 300,000 shares, worth more than $15 million at Sunbeam's high. Half a year after the deal was struck, the stock sank from over $50 to under $10 on news of accounting irregularities. Dunlap was fired, but he wants severance--namely, his $2 million in annual salary until 2001. Then there's Computer Associates, where top executives recently profited from a cozy deal. Back in 1995, Computer Associates' board agreed that if the stock stayed above $53.33 for 60 days in any 12-month period, CEO Charles Wang and two top lieutenants would pocket over $1 billion worth of stock. On May 21, 1998, the hurdle was cleared, and the execs got their wads. Two months later the stock fell more than 30% on worries about the company's earnings outlook.

Apart from such horror stories, that old cliche about "bull market genius" explains a lot of what's going on--Wall Streeters who are collecting millions by being in the right place at the right time, corporate executives who are pocketing above-average salaries while their companies underperform their peers. "The rising market alone has moved lots of compensation to the point where it's completely unrealistic," says Peter Gonye, an executive recruiter at Egon Zehnder.

But there are a couple of more basic factors layered on top of the bull market that are pushing salaries skyward. One is simple supply and demand. Stressed-out financial-services headhunters say that even 30% to 50% pay increases are no longer enough to lure someone to a new job. Peter Crist, a Chicago-based recruiter, says he's in the process of hiring a 35-year-old mid-cap value manager with a good performance record away from a Boston firm. The manager is getting a "two, three, five" deal: a minimum of $2 million the first year, $3 million the second, and $5 million the third. Crist also says that big firms like General Electric, which historically have had lots of bench strength and little use for recruiters, are now being forced to turn to search firms.

The other factor behind the monstrous sums--oddly enough-- is the concept of pay for performance. That's always been the culture on Wall Street; even today base salaries on the Street are usually under $200,000. It's the performance-based bonuses that can be ten times that amount. Obviously, performing in this market is none too challenging.

In corporate America, pay for performance began to gain widespread popularity in the late 1980s. The common currency: stock options. Not only did options seem a clear way to link shareholders' interests with executives', but in accounting terms they are free money (companies needn't deduct the cost of options from their income statements, yet they can deduct it for tax purposes). No one foresaw that the bull market would turn reasonable-sounding grants into gazillions. Just under half the median CEO's compensation last year came from realized option gains; Mercer estimates that the median CEO is sitting on another $9 million or so in unrealized gains.

At this point, high compensation is a self-fulfilling prophecy. "We've created something of a Frankenstein," says Nell Minow, a principal at shareholder-activist firm Lens. Boards of directors determine appropriate pay scales by--how else?--evaluating what everyone else is paying. "It's very much based on the concept of the Joneses next door," says Judy Fischer, director of Executive Compensation Advisory Services. This inflationary spiral spirals yet higher when it comes to recruiting rainmakers. You have to "make them whole"--pay them for any stock they are leaving behind--tack a substantial incentive onto that, and take into account what a competitor might pay to nab them. And when the person departs for the next job, his asking price is that much higher.

You might notice a certain irony in all this. The management mantra of the 1990s has been "teamwork." Yet we've created a star system in which those at the top collect the major share of the rewards. You also might think that it makes sense to ask, "Are these people really worth those sums?" The simple truth is that in many cases, we're all too fat, dumb, and happy to care. Last year Travelers' market capitalization increased by over $22 billion. Anyone want to quibble with Sandy Weill's $230 million?

Actually, devising calculations to measure bang for the buck misses the point. Rank-and-file employees are paid based on services rendered. Corporate executives are not. "It's ego pay, not economic pay," says Mercer consultant Yale Tauber. Hence, whether Sandy Weill's services are worth $230 million is irrelevant. The money simply provides a means of measuring one's standing relative to one's peers. So take pity on the poor Wall Streeter or corporate chieftain who takes home a million bucks when his neighbor takes home two million. He's second-rate!

What is irritating is that there's one element that's increasingly getting left out of both Wall Street and corporate compensation schemes: risk. If someone is putting a lot on the line, the potential for a huge payout doesn't seem so absurd. But that's not the way it works anymore. "For all the bravado, the Wall Street crowd is incredibly risk averse when it comes to their own money," says Egon Zehnder consultant Alan Hilliker. That risk aversion crops up in the form of guarantees--even if I sit on my butt for the next two years, you agree to pay me some exorbitant sum.

In executive suites, that unwillingness to accept risk flows through every part of the compensation agreement--from what Mercer's Tauber calls "golden hellos" (we'll pay you to come) to retention bonuses (we'll pay you just to stick around) to golden parachutes (we'll pay you to leave). Those little perks come on top of the minimum requirement: replacing what the new recruit is leaving on the old company's buffet. AT&T's new CEO, C. Michael Armstrong, came from Hughes Electronics, where he was guaranteed $10 million in 2003. As a result, in 2003, AT&T will fork over the same amount, no matter what its stock does in the intervening years. "If you want a star, he'll demand downside protection," says consultant Ira Kay at Watson Wyatt.

Some obvious suspects are squawking about all this. The AFL-CIO devotes a Website to executive overpayment. Rep. Martin Sabo (D-Minnesota) is sponsoring a bill that would limit the tax deductibility for executive compensation to 25 times the salary of the company's lowest-paid full-time worker. And there are moves to link pay more closely to performance--for example, by setting the option's exercise price above the stock's current level or by indexing options to peer-group performance.

Still, people have been talking reform for years, and it's unwise to underestimate the ingenuity of those grown accustomed to deluxe salaries. Wall Streeters, nervous about a bear market, are becoming more appreciative of cash. "On Wall Street, paper has value only if it's the right moment in a market cycle. Right now people like cash a little more," says Hilliker.

Executives, too, will probably find clever ways to take the bite out of performance requirements or to get around a sliding stock market. Mercer notes that so-called megagrants--ones that have a face value of at least three times an executive's salary and bonus--are gaining popularity. And there are cases already in which companies have "repriced" options--lowered the exercise price to make up for a sagging stock. "If the market slides below 8000, a lot of options will be underwater. Then expect to start hearing that the market isn't a good judge of performance," says Tauber.