|
March 14, 2000
Indexed Stock Options Reward Performance
The controversial alternative to standard options has few supporters among corporate managers, but
could stem the recent CEO compensation glut.
SocialFunds.com --
During the period 1990-1998, corporate profits rose 108 percent, and CEO pay rose 481 percent, but
the average worker's pay rose just 28 percent, barely more than inflation. Shareholders and other
citizens outraged by the growing discrepancy between executive compensation and all reason may find
some solace in the suggestion of indexed stock options.
 Stock options are the single most
important factor pushing the average large company CEO pay to 419 times more than the average
manufacturing worker. Indexed stock options are a method for putting these rewards into
perspective, by linking them to an "index" that measures the relative performance of the company.
"We believe it is inappropriate to compensate senior executives for improvements in
company performance that are attributable to factors beyond their control," said Beth Young,
Shareholder Initiatives Coordinator at AFL-CIO. "Examples of such factors are a general stock
market rise in response to interest rate changes or a rise in the price of all airline stocks
because of a drop in fuel prices."
Standard stock option grants are exercised at the fair
market value on the grant date, even years later when the shares may be worth twice as much or
more, often providing millions of dollars in additional executive compensation, regardless of the
relative performance of the company.
"Little effort has been made to link executive
options to performance, other than the clear link between ultimate option gains and increases in
shareholder return," said Fred Whittlesey, founding Principal at Compensation and Performance
Management (CPM), Inc. CPM is a Newport Beach, California-based consulting firm for
performance-oriented compensation programs, and a strong advocate of indexed options.
Indexed options, as opposed to regular options, do not provide compensation unless the company
outperforms some index, either a general index like the S&P 500 or a peer group index. They are a
promising method for linking executive compensation to performance, providing a more effective
motivation for company management.
The exercise price for an indexed option is not known
at the time of grant, but is set by reference to the given index. For instance, if the index group
experiences an average share price increase of 10 percent, the exercise price for the option would
be 10 percent above the fair market price at the grant date.
Indexed options are thus a
reward for relative rather than absolute performance, not providing compensation unless the company
stock outperforms the index. While this may make the options less valuable in a bull market, there
is also the potential for compensation even in a declining market if the company stock declines
less steeply than its peers.
The most common argument against indexed options is that they
result in what companies like to call an "adverse accounting treatment" - they apparently "cost"
more. Regular stock options are considered "free" because there is no difference between fair
market value and exercise price. Indexed stock options, on the other hand, result in a different
exercise price from the market value at grant date, thereby incurring an "expense."
"Expensing results in lower earnings, so companies try to avoid it," said Young of AFL-CIO.
"Right now, regular stock options allow companies to have what is essentially a free ride in this
respect."
"Indexed options are an obvious solution to many perceived compensation issues,"
said Whittlesey of CPM. "Yet current accounting rules in the U.S., which are continuing to diverge
from economic reality, reinforce the aversion to their use."
The argument of adverse
accounting treatment ignores the hidden costs of stock options to shareholders. In the end, indexed
options that deliver less compensation cannot cost more than fixed-rate options that deliver more
compensation. The root of resistance may be here, in that ultimately executives stand to make less
on their options.
Although indexed stock options have been endorsed by Federal Reserve
Chairman, Alan Greenspan, they have not been embraced by most corporations. Only one major company
currently uses indexed options, Level 3 Communications, a Broomfield, Colorado, telecommunications
firm, but that could change as shareholders join the bandwagon.
"The most vocal
supporters of indexed options have been in Europe," Said Whittlesey of CPM. "It may be that this is
the first time that European compensation trends influence U.S. compensation trends."
Last year, the AFL-CIO staff fund sponsored a proposal asking Chubb to adopt either indexed or
so-called "premium-priced" stock options, whose exercise price is set above the market price at
date of grant. Following their lead, shareholder activists are likely to add this solution to their
quiver of strategies used to stem the tide of unreasonable compensation.
©
SRI World Group, Inc. All Rights Reserved.
Top
| 
