Make CEOs earn their pay: here is how compensation committee members need to start thinking about the next generation of stock options.

AuthorRappaport, Alfred

THE HIGH-DECIBEL DEBATE over executive compensation is largely about undeserved pay. Troublesome disconnects between CEO pay and performance can be found in virtually all publicly traded companies. Neither giving shareholders "say on pay" nor imposing upper limits on compensation will get the job done. We believe the standard stock option plan needs a major overhaul so that executives are rewarded only when they deliver superior long-term returns to shareholders. This is the way for boards to ensure that CEOs earn their pay and the way compensation committee members need to start thinking about the next generation of stock options.

In the early 1990s corporate boards became convinced that the surest way to align the interests of managers and shareholders was to make stock options a significant component of executive compensation. But this intended long-term incentive only increased the obsession with Wall Street quarterly earnings expectations, often at the expense of longer-term value and the health of the company. Furthermore, even CEOs who delivered mediocre returns to shareholders were rewarded with huge option gains.

Too short and too low

What went wrong? Two basic factors limit the ability of standard stock option plans to motivate long-term value-maximizing behavior--holding periods are too short and performance targets are too low. Short vesting periods, typically three or four years, enable executives to exercise their options and promptly cash out shares, thereby diminishing the long-term incentive that options are intended to provide. As became painfully evident in the 1990s, in a rising market options can reward even poor performance because executives profit from any increase in share price--even one well below that of competitors or below a broad market index like the Standard & Poor's 500, or even below the return on safe investments like Treasury bonds.

Just how easy is it to realize gains from options when the stock market is rising? For the 10-year period ending Dec. 31,1999, all of the 100 largest U.S. companies appearing on the Wall Street Shareholder Scoreboard produced positive returns and all but 16 generated average annual returns exceeding 15%. In addition, and not surprisingly, during much of the 1990s pay for performance and other corporate governance concerns took a backseat as investors enjoyed annual double-digit stock price increases.

But standard option plans also failed the pay-for- performance test in a...

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