That's definitely the proper way of doing it, but for a CPU performing this poorly even the most amazing thermal compound isn't going to reduce the temperatures much. I'd be interested to see temperatures with direct mounting on the exposed die although I don't have the ability to mount a cooler like that.If there's solder on the chip, and you put HS compound on top, you'll get terrible temperatures.
The indium solder is so jagged on a microscopic scale, that it doesn't make good contact.
Scraping it off with a razor blade until you get to the die, and then lapping it with 1000 or 2000 grit wet-or-dry emery cloth will make a nice difference.
I didn't realize there was a Xeon version of the Pentium D chips.
I actually got a refund on the dud chip because the seller had sent the wrong stepping to begin with. That's probably not the true cause of the high temps, but it means I can order a new L5420 SLBBR from a different seller and see what the new one is like.