Executive compensation is made up of a base salary plus; long-term compensation, annual bonuses, retirement contributions and options. The principle objective of these managerial bonuses is to align the efforts of managers with the interests of shareholders. 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 2008)
By far the largest 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 employee stock option 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). Stock options give the employee an opportunity to buy a specified number of shares in a company at a future date, for an agreed price. This gives the employee a right to exercise the option when he/she wants to within the specified time. Stock options provide a financial benefit to the recipient only if the stock price rises over the period the option is available. If the stock price falls over the period, the employee is under no obligation to buy the stock. De Cieri (2005) claims that a potential advantage of employee stock options is that it may encourage employees to think more like owners, taking a broad view of what needs to be done to make the organization more effective.
Along with aligning shareholder and managerial interests some of the other reasons why so many companies choose to use stock options to compensate employees are to attract and retain good, qualified employees; they can make it acceptable for the company to pay a lower base pay to managers; more tax efficient method of paying employees; increases employee loyalty; and they can serve as a means of starting a savings plan. This, at first glance appears to fit the most favourable 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 some 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. 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. Thus, stock options are an unattractive means of recruiting talent during economics slowdowns, where even if a manager had made substantial improvements, it will go unrewarded due to forces external to their control. Therefore, this bonus type would be more dependent on market conditions (good fortune) rather than individual contributions.