|
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
|
