An attractive alternative to a peer index.

• Author: Rappaport, Alfred
• Position: CEO COMPENSATION - Reprint

Corporate boards can overcome many of the serious shortcomings of standard stock option programs by adopting a plan that rewards executives only if they create superior long-term value. One potential solution is an indexed-option plan that requires executives to retain a meaningful fraction of the equity they obtain well after the vesting date.

Unlike standard options that have a set exercise price, indexed options have an exercise price that rises or falls based on an index of the company's competitors or a broader market index. For example, if the chosen index increases by 10 percent, then the exercise price of the options increases by the same percentage. As a result, the options are worth exercising only if the company's shares rise by more than 10 percent.

Indexed option plans, unlike fixed-price option plans, ensure that underperforming executives are not rewarded simply because the market is rising. Nor do they penalize superior performers in a falling market. If the peer group or market index declines, then so does the exercise price, which provides executives with a continuing incentive to increase value. With standard option plans, a hear market can overshadow superior performance and cause executives to lose wealth precisely when they provide the best relative results. Both the free ride in the bull market and the undue penalty in a bear market undermine the effectiveness of the standard stock option plan. Indexed options, by contrast, reward superior performers in all market environments.

Some observers object that executives profit when they outperform the index even if the stock price falls below the exercise price at grant date. To counter this objection, boards can require that options be exercised only if the company's stock is trading above its price at grant date or if shares have appreciated at a specified minimum annual rate.

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One practical challenge in implementing an indexed option plan is determining whether it is better to tie the exercise price to an index of the company's competitors or to a broad market index, like the S&P 500, A market index is transparent and easy to track, but does not reflect the specific factors that affect the company's industry. As a consequence, a market index is not an ideal benchmark for measuring management performance. An index of the company's competitors is a better choice. But many companies do not have a clear and suitable set of peers. This is particularly...