William M. Mercer, a pay consultancy, says that only 18% of the compensation of American chief executives (and 40% of that of British chief executives) came from fixed salaries last year. The rest came from variable sources such as stock options and other performance-related bonuses. [Under Water, Economist, Oct 2001] By far the biggest contributor to salary earnings in the US, less so in the UK, but still the significant portion is derived from performance related bonuses, both short term and long term incentive schemes.
A study conducted by PricewaterhouseCoopers found that amongst the FTSE 100 chief executives, bonuses alone averaged 46. 9% of base salary and share options remain the most popular long-term incentive [Financial Times, September, Jan 2001] Michael Dell, chairman CEO at Dell Computer Corp. , drew $199. 6 million in compensation, down 15%. Some 99% of his compensation came from options exercised[Financial Times, 2000]. Dell’s lucrative compensation is another example, although an extreme one, of how performance related bonuses such as share options have become major contributors to CEO earnings.
Although, it is fair to point out that Dell’s sustained success both in the accounts, and on the stock market warrants a lucrative compensation deal for the charismatic CEO – especially, if the financial decline of competitors, and the overall slowdown in personal computer sales is taken into consideration. The 1984 Finance Act facilitated the implementation of executive share options [Brett]. Share options could be described as a share price guarantee. The manager is granted the option of buying shares at a certain price (usually the market price at the time of the grant) at any time.
If the share value increases, the manager can effectively purchase the shares at the pre-determined price, and exercise them at the new market rate – thus, provided the share price has risen, the manager stands to gain considerably. This, at first glance appears to fit the optimum bonus system, in that the shareholders interests (greater share value) have been integrated with the level of bonus received by managers. If the manager can demonstrate to the shareholders that he or she has effectively increased the net worth of the shareholder, the manager shall receive a monetary reward through the exercise of share options.
However, there are flaws in this system: During periods of Bull market, where share prices are, on the whole, being driven higher and higher – an increase in share value for an individual firm may be attributed to external market conditions, regardless of the senior executive’s contribution. Hence, managers may be rewarded, despite performing at a below-par standard. Therefore, the use of share prices to determine significant proportions of managerial remuneration becomes questionable as a measure (second part of bonus system).
Rappoport insists that share prices are an effective method of measuring performance at the very top of the organisation. However, the benchmarks or standard of performance expected by the board are either weakly defined, or easily influenced by external market conditions. “… current stock options reward both mediocre and superior performance. In other words, the board are not setting the right level of performance” [Rappoport, 1999] Rappoports assertion that the correlation of performance related rewards and the actual level of performance is actually very fuzzy is substantiated by the following extract from a journal article.
The study found the largest disparities between share price performance and compensation increases occurred at the manufactured housing companies Champion and Oakwood, where Walter Young and William Edwards received increases in compensation of go percent and 61 percent, respectively, despite share price declines of 68 percent and 67 percent.
Conversely, Dwight Schar, CEO of builder NVR, received an increase in compensation of only 12 percent, despite an increase in share price of 159 percent Mysteriously, D.R. Horton CEO Donald Tomnitz received a 29 percent decrease in compensation, despite a 45 percent increase in share price. [Walker-Guido, Builder – Washington, Sep 2001] Rappoport suggests improvements can be made through the use of indexing to measure how well the firm has performed, in line with it’s competitors, or industry peers. Indexing eliminates the influence of external market effects on share price, and thus allows the contribution of the senior executive to be measured most effectively.
Hence, the use of indexed options rewards only those managers that have achieved superior performance. Althought, Rappoport adds that to entice managers to the new system, which places tougher measures on their performance, will require boards to provide more options, and possibly lower the exercise price – thus allowing managers that exhibit superior performance to be rewarded at the same level as the previous fixed price stock options would provide. The use of performance related stock options provided massive increases in managerial compensation up until the late nineties.
Boards could leverage these, by maintaining basic salary levels, but provided the promise of financial gain through stock options, provided the periods of sustained growth continued. Thus, increasing share values where taken as given, which may have created an automatic assumption or even complacency that these options will always come to fruition at a higher value. However, the current economic slowdown, and general fall in share value has led to some stock option going ‘underwater’, or valueless (i. e. current price less than the granted price).
Therefore, the use of stock options to attract entrepreneurial talent, especially at the top of the organisation will have a limited effect. The economy currently is hovering somewhere between inflation and recession. In either case, the likelihood remains that it may be several years-if ever-before any of the recently issued stock options have any real value. Absent any alternative benefit arrangements, there is little else offered to retain current executives, and typically cash compensation alone won’t do it. [Ellerman, Compensation and Benefits Management, Autumn 2001]