Thursday, October 11, 2007

Executive pay: Out of the money

Nowadays, options make up the bulk of high-level executive compensation. They are hailed as an efficient way to align the interests of management with those of shareholders. But is this true?

This piece in The Economist presents evidence to the contrary:

Belatedly, the evidence is now mounting that share options are not all they were cracked up to be. Consider, for example, “Swinging for the fences: The Effect of CEO Stock Options on Company Risk-taking and Performance,” a study in the October issue of The Academy of Management Journal.

The authors, two economists, Gerard Sanders and Donald Hambrick, observe that options create asymmetric incentives: they pay out when a firm’s share price rises above the option exercise price, but once they fall below the exercise price, all further falls make no difference to the ultimate payout, which is nothing. This, posit the authors, gives an incentive to take big bets, by investing in risky activities with long odds on a high pay-off. They also posit that these bets will produce more extreme losses than extreme wins.

To test these theories, they examine the impact of the options awarded to the chief executives of some 950 American firms during 1993-2000. This showed that the bigger the role played by share options in the boss’s pay package, the more likely firms were to invest heavily in risky activities. It also confirmed that high levels of share options were associated with more extreme ups and downs in a firm’s share price, and that the big downs significantly exceeded the extreme highs.

The authors conclude that “not only does this asymmetry affect the selection of strategic initiatives, as we have discussed, but it may also cause CEOs to be inattuned to early signs of project failure and generally careless about risk mitigation.” Surely this is not the sort of motivational incentives that shareholders want.

These results are not suprising and my guess is that they would've been much more evident if there hadn't been a huge bull market for stocks during that period.

It's not just a question of asymmetrical payoffs. My main beef with options is that they only reward absolute rather than relative performance.

In lackluster or bear market conditions a firm may have outsanding operational and financial results and yet see its stock price fall simply due to macro factors outside its control. Conversely, in a bull market a firm's stock price may rise despite poor results relative to its competitors. Executives would receive a large payoff in the second case, but not in the first, an outcome that defies all logic.

Yet, I have yet to see a compensation plan that takes this issue (or others, such as favoring short-term appreciation versus long-term gains) into account. Strike prices are usually the price of shares at the time the options are issued.

Outrage about executive pay is misplaced. Focusing only on its level is not helpful. It may or may not be excessive. But the real problem is that the way compensation is determined makes no sense at all.