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Stock Options And Executive Pay

News

Executive pay in the United States soared to record highs last year. A typical Chief Executive Officer (CEO) of a Fortune 500 company earned an annual compensation of $7.8 million, a 54% increase over last year. The compensation far outpaced the 11% increase in corporate profits and the 23% rise in Standard & Poor's 500-stock index. Meanwhile, the average compensation for factory workers inched up a meager 3%. The 200 times disparity is five times greater than it was 30 years ago. (Business Week, April 21, 1997, page 59, Time, April 28, 1997 )

It is not just the CEOs that are reaping the benefits. For instance, in 1996 the average Intel employee received 33% above base pay in stock options. At Cisco Systems and Ascend Communications, a considerable number of employees have boosted their net worth to seven digits. (Fortune, April 14, 1997 )

Top Paid CEOs

  1996 Salary & Bonus
($ 000)
Long-Term
Compensation
Total Pay
LAWRENCE COSSGREEN
TREE FINANCIAL
$1102,449 NONE $102,449
ANDREW GROVE
INTEL
3,003 $94,587 97,590
SANFORD WEILL
TRAVELERS GROUP
6,330 87,828 94,157
THEODORE WAIT
GATEWAY 2000
965 80,361 81,326
ANTHONY O’REILLY
H. J. HEINZ
2,736 61,500 64,236
STERLING WILLIAMS
STERLING SOFTWARE
1,448 56,801 58,249
JOHN REED
CITICORP
3,467 40,143 43,610
STEPHEN HILBERT
CONSECO
13,962 23,450 37,412
CASEY COWELL
U.S. ROBOTICS
3,430 30,522 33,952
JAMES MOFFETT
FREEPORT-McMORAN
6,956 26,776 33,732

Analysis

Executive stock options are aimed at inducing managers to act in the best interest of shareholders by maximizing the value of the company. By tying part of the pay to actual performance as measured by the price of the stock, managers would be more likely to work hard to increase the price of the stock; otherwise, they would forego the additional compensation.

The explosion of executive pay was propelled by executive stock options combined with a bull market.

Downside
Besides issues of income distribution, stock options come with hidden costs. Business Week has pointed out the following issues:

First, unlike regular pay, they don’t enter the calculations of the income statement. Starting this year, their value has to be reported as footnotes in annual reports. PepsiCo’s income, for example, would have been reduced by $68 million, or 6%, had they been reported as part of compensation.

Second, the price at which these options can be converted to stocks is typically set at a low level such as at current or $1 over current market prices. With such ridiculously low prices, there doesn’t seem to be a compelling need for executives to work hard to boost stock prices, especially at a time when the stock market keeps up an unprecedented momentum toward new record highs. Only about 6.6% of companies granted options with a conversion price above the market price. For instance, a meager $2 increase in Disney’s price would increase the market value of its CEO’s stock options by $10 million.

Third, a number of executives have also negotiated protection in the event that the targets are missed. For example, in 1995 Digital Equipment CEO Robert B. Palmer was granted 300,000 options at the then-market prices or $48. However, the following year, the target price was reduced to $37.75.

Fortune magazine has pointed out two additional drawbacks to stock options. First, the incentive is lopsided as it rewards price increases but does not penalize the opposite. This feature gives managers incentive to take undue risk. Second, it works against companies that are undergoing restructuring. Stock prices of such companies tend to lag behind peer companies; thus, employees have incentive to jump ship to a competitor. Companies like Apple and Sybase are finding it very hard to retain good talent.

What is Being Done To Remedy The Problem?
The AFL-CIO has designed an Internet site (www.paywatch.org) that explains how to complain to directors and the process of filling a proxy.

Companies like DuPont and BankAmerica grant CEO stock options that can be cashed only after the stock has risen to a specific level. Some compensation specialists have advocated stock options that are indexed to the market, which is typically measured by the Standard & Poor’s 500 (S&P 500).

KEY CONCEPTS
Agency Costs Costs to the firm, associated with the potential for conflict of interest between management and shareholders when these two groups are different.

Agency Theory Theory concerning the relationship between a principal (shareholder) and an agent of the principal (company's managers). It involves the nature of the costs of resolving conflicts between the principals and agents.

Objective of the manager The maximization of shareholder wealth by maximizing the market price of the existing stock.

Options An option is a contract that gives its holder the right, but not the obligation, to take a certain action in the future. With executive stock options, the action is to buy a specific number of company shares at a reduced price only if the stock price reaches a certain level.

 

By Alex Tajirian


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