VideoCertainly the current trend has created an unparalleled pay environment for CFOs. How long it will last, of course, is anyone's guess. But as long as compensation costs themselves don't threaten stock prices, and options continue to be the favored recruitment vehicle, shareholders are unlikely to complain. "Everybody's fine with [the trend] as long as [the market] goes up," says David Leach, national director of compensation consulting for Buck Consultants, in New York.
Going Long
The use of stock options has been rising along with stock prices since the early 1990s, but has widened beyond top management during the past few years, thanks largely to the New Economy. And not surprisingly, Internet CFOs get the highest proportion of their pay — 73 percent — in the form of options and other long-term incentives. Yet the survey also found that Internet CFOs weren't the highest-paid finance executives. On the contrary, on average, finance chiefs in more-traditional industries, such as pharmaceuticals, all took home bigger paychecks.
What explains the discrepancy? At this point at least, CFOs within the Old Economy exercise responsibility over a far greater amount of capital than do Internet CFOs. "The scope of [the former's] responsibilities is much greater than those of an Internet CFO," notes James Knight, a partner at SCA Consulting, a management consultancy in Chicago. And though much more of the New Economy's assets may be intellectual, finance executives still aren't paid as much to manage intangibles. Of course, there are some glaring exceptions to this rule, as reflected in our list of the 10 most highly paid New Economy CFOs.
In any case, the use of options isn't limited to CFOs in the New Economy or the Old. The Towers Perrin survey indicates that companies are using options to reward divisional CFOs as well as corporate finance chiefs. While receiving an average of $306,900 in salary and bonus, group-level CFOs, for instance, earned an average of $243,900 in options and other long-term incentives last year. In fact, the pattern holds throughout the hierarchy of corporate finance. Corporate-level treasurers earned an average of $245,700 in the form of options and other long-term incentives. Group-level treasurers got an average of $80,000 in this fashion. Group-level controllers earned even more — an average of $114,000 via long-term incentives.
But is the trend toward options ultimately a good thing? Despite the widespread use of options, a growing body of evidence suggests they may end up killing the golden goose. A study by Wm. Gerard Sanders, a professor of strategy at The Marriott School of Brigham Young University, is only the latest to find that options encourage managers to make acquisitions.
To some degree, this reflects the fact that traditional options are not truly linked to operating-performance targets or even superior stock performance. In virtually all cases, executives who deliver less shareholder value than their peers or the overall market are nevertheless handsomely rewarded. And while their options' value requires the stock's price to go up, that may not take much.
Consider again the top earner on our top 25 list, James Hance of Bank of America. He was awarded $49.2 million in long-term incentives, half in stock options, even though the company's stock lagged the overall market last year by 35 percentage points, as well as those of other large banks by 3 percentage points. Investors in Bank of America were disappointed by the effect of the Federal Reserve's interest rate hikes, as well as with poorer-than-expected results from the bank's 1998 merger with NationsBank. A company spokesperson explains that Bank of America outperformed its peers in 1998 and wanted Hance "to stay with the company for the next number of years." The spokesperson adds that such incentives are "an accepted way" of retaining executives.
Worse still, compensation policies at many companies have allowed options that are out of the money to be repriced downward, so executives who fail to deliver shareholder value ended up being rewarded anyway. Repricings will no doubt dwindle in the wake of a recent ruling by the Financial Accounting Standards Board that requires companies to take a charge to earnings for such actions. Witness Microsoft Corp.'s move to double the number of options granted to its employees in the wake of the stock's recent sharp decline. Instead of repricing options that are now underwater, the company chose to issue new, lower-priced ones.
A Mere Detail?
But even options that aren't repriced represent an expense to shareholders, though it isn't fully reflected on corporate income statements. That's because the expense associated with the traditional grants needn't be included in income statements, but merely footnoted. As a result, companies that depend heavily on option grants report inflated earnings growth. A recent study by the Federal Reserve Board estimates the inflation to amount to roughly 1.5 percent annually. And while investors may not notice or care in the short run, they eventually will, or studies suggesting that the market is efficient are mistaken.
In fact, there is evidence to indicate that investors do care about the cost of stock options, at least insofar as the grants dilute their earnings. That dilution is reflected in the difference between basic earnings per share and diluted EPS on the income statement. And a study of market data from 1989 to 1995 published in the November/December 1997 issue of the Financial Analysts Journal found significantly greater correlation of stock prices to diluted earnings than to undiluted.
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