An Answer to the Options Mess

How to ensure that top execs aren't rewarded even when their outfits perform poorly? Index stock options to a benchmark like the S&P 500

By Christopher Farrell

The populist outrage against chief executives and their option-bloated compensation packages is strong. It's not just the usual round of consumer activists and opportunistic politicians expressing anger and calling for change. No, the disgust is apparent in comments from ordinary investors during my public radio show Sound Money and while I'm on the road interviewing folks for my public television program Right on the Money.

The ill-temper goes all the way up the investor spectrum to capitalist icon Warren Buffett, who is fed up with "the situation, so common in the last few years, in which shareholders have suffered billions in losses while the CEOs, promoters, and other higher-ups who fathered these disasters have walked away with extraordinary wealth." He adds in his latest annual letter to Berkshire Hathaway shareholders: "To their shame, these business leaders view shareholders as patsies, not partners."


  Buffett is right, sad to say. Gather a large stack of recent BusinessWeeks, and the evidence is compelling that the management abuses at Enron, while extreme, are too widespread for comfort. The modern-day CEO is all too adept at reaping enormous gains from stock options no matter how the company performs.

Tyson Foods CEO John H. Tyson received a $2.1 million bonus and 200,000 new options last year even though net income fell by half and shareholder returns were flat at his company. Former IBM head honcho Lou Gerstner pocketed $303.2 million over the three-year period of 1999 through 2001, while shareholder received only a 33% gain on their holdings. Over the same stretch, Cisco Systems shareholder returns declined by 22% even as CEO John Chambers collected $279.3 million. (These figures come from BusinessWeek's Apr. 15 special report on executive pay.)

The critical question is how to preserve the benefits of stock options while containing the downside. It's an axiom of modern finance theory that the only way to create an opportunity to earn higher returns is to take greater risk. For instance, stocks are riskier to own than fixed-income securities, and holding a handful of high-tech stocks is far riskier than investing in the Standard & Poor's 500-stock index.


  The current problem with options is too many CEOs are earning windfalls for doing nothing more than riding a rising stock market. Corporate boards should index executive options to a benchmark such as the S&P 500 or the Wilshire 5000. Managers thus would profit from their option grants only to the extent that their initiatives beat the market index. By indexing options, the grants would reward the extraordinary entrepreneur and not the ordinary caretaker.

At the same time, there's no justification for repricing options to a lower strike price when the market is down. "If the exercise price could be linked to measures like the S&P 500 or an index of close product market competitors, then executives would be rewarded for gains in stock prices in excess of those explainable by market factors outside their control," write economists J.M. Abowd and D.S. Kaplan in "CEO Stock Option Awards and the Timing of Corporate Voluntary Disclosures" (Journal of Accounting and Economics 29, pages 73-100).

Considering current stock-option compensation practices, it's little wonder the backlash against options is gaining momentum. Still, options remain a valuable financial tool for rewarding managers and workers. Despite the abuses, options do tend to align management and shareholders interests, as well as encourage managerial entrepreneurship.


  It's worth recalling that U.S. companies stumbled horribly in the '70s. Industrial America lost market share and profits to Japanese, German, and other overseas rivals. Productivity growth faltered to less than a 1% annual rate. Management adopted a risk-averse mentality (no innovative ideas, please), loaded up on executive perks (get it while you can), and isolated itself from pesky shareholders (the CEO as emperor). The chief executive mind-set of that era was economically catastrophic.

T. Boone Pickens, Michael Milken, Henry Kravis, Carl Icahn, and other financial gunslingers shook America's defeatist Establishment out of its gloom. But too many companies foundered on the leverage these financiers favored. Stock options proved to be a better incentive to get managers to take risks. In 1980, chief executive compensation was mostly in cash and bonuses, with only 30% receiving new option grants, according to John E. Core, Wayne R. Guay, and David F. Larcker, accounting professors at the University of Pennsylvania's Wharton School. Mean salary and bonus was $655,000, and new option grants $155,000.

By 1994, options had become a major part of CEO compensation, with 70% receiving new option grants. Mean salary had risen to $1.3 million and mean option grants to $1.2 million, the authors calculate in their paper Executive Equity Compensation and Incentives: A Survey. Options played a role in the longest economic expansion in U.S. history.

Congress is mulling several legislative proposals, ranging from limits on option grants to requiring the expensing of options on the income statement. But corporate boards should index executive options to preserve the entrepreneurial benefits while eliminating a major source of unfairness.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Beth Belton

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