VideoThroughout the 1990s, stock options were widely seen as a panacea for all compensation woes — they linked executive behavior with shareholder value and offered a "cost-free" way to compensate employees for taking risks on start-ups. In retrospect, of course, options bear a more striking resemblance to fool's gold — a jackpot for the executives who collect them, but a bust for investors, who learned too late that share price more often reflected market forces than managerial genius.
Not to mention the temptation to greed posed by such massive amounts of easy money. The signature frauds of the early 21st century owed much to option payouts, as do the more recently uncovered backdating scandals.
In recent years, companies have let the stock option play a much smaller role in their overall pay plans. Nearly every public company issued options five years ago, according to The Corporate Library, an independent research firm that analyzes corporate-governance trends. Today, it says, only two-thirds do. And while the commitment to stock options is greatest among America's largest firms, even the corporate giants have scaled back sharply.
One such company is Agilent Technologies. Three years ago, the Santa Clara, California-based measurement-products company announced an executive incentive plan split evenly in value between "performance shares" and stock options. The performance shares provide full-value stock based on how the company stacks up relative to its peers. Previously the plan had consisted of options alone.
"We did a study and found that half of Agilent's share-price movement is driven by economic and industry factors and half by company performance," says Dominique Grau, vice president of compensation and benefits. In a rising market, the performance shares strip out much of the increase caused by overall market results. When share prices fall, the company still can reward executives if Agilent outperforms its peers. "This is a much better way of compensating our executives," says Grau. After completing the first three-year performance cycle next year, the company plans to rethink the balance between options and performance shares, possibly increasing the performance-based portion.
Agilent's experience illustrates where compensation trends are heading. Companies are relying more on performance-linked equity, in combination with other forms of pay. But the question of which performance measures are best stirs heated debate, and confusion abounds about designing the right overall system. The accounting issues can be nettlesome, and executives often disagree on just how much pay should be performance-related in the first place.
"In the past, companies just defaulted to options," says Steve Van Putten, who runs Watson Wyatt Worldwide's executive-compensation practice on the East Coast. "It's become more complex."
A Split over Restricted Stock
The flight from stock options has been hastened by two practical considerations. The popping of the tech bubble rendered many options worthless, forcing companies to seek other ways to entice executives to stick around. Then came the Financial Accounting Standards Board's FAS 123R, which required the expensing of options, removing the cost advantage that options once held for companies.
As they shopped for alternatives, directors first settled on time-vesting restricted stock. That pay form had lost much of its popularity in the era of stock-option mania. But the full-value shares remained attractive as executive compensation because, while the price may fall, the stock retains some value. To some companies, restricted stock also seemed a more shareholder-friendly choice, partly because it creates less dilution than options. Since one restricted share has more value than one stock option, companies need to issue fewer shares under a restricted-stock regimen.
But investor advocates don't like restricted stock either. Some call it "pay for stay," since employees need only avoid getting fired to earn their stock. "Somehow companies got the impression that the corporate-governance lobby had encouraged restricted stock," notes Paul Hodgson, senior research associate with The Corporate Library. "It said nothing of the kind."
The use of restricted stock has continued to rise, nonetheless, often in combination with performance-based compensation. As the first article in this series explained (see "Pay Dirt"), the Securities and Exchange Commission's new rules on disclosure offer fewer places for boards to hide the terms of compensation awards from shareholder scrutiny. "Now that the disclosure rules have been confirmed, we're seeing compensation committees finally asking themselves, 'How are we measuring performance? And how well are we linking that with all of the rewards we're paying out?'" says Myrna Hellerman, senior vice president with Sibson Consulting, a human-capital advisory firm.
Performance-linked pay comes in all sizes, shapes, and flavors. The Boeing Co. links cash payouts to beating a three-year target for economic profit. Sara Lee Corp. passes out stock options to managers if a predetermined stock price is hit. General Electric Co. grants stock when the company meets a combination of goals, such as cash-flow or relative shareholder return targets.
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