October 15, 2003
Even more scrutiny has been placed upon executive
compensation following the forced resignation of Dick Grasso as head of the New
York Stock Exchange.
A recent symposium on the use of stock options in
compensation was published in the Journal of Economic Literature. While it does not address the pension
program so dramatically exploited by Grasso, it sheds light on why compensation
has become so huge relative to norms in recent years.
Actually, Grasso's pension program is not dramatically
different from what is called a defined benefit program. The percentage of benchmark pay that an
employee receives in retirement normally depends upon years of service. Dick Grasso was at the stock exchange
for more than 30 years. Therefore,
he qualified for a maximum percentage of that benchmark pay in retirement.
In a defined benefit program, the benchmark usually is the
amount of earnings in the latest years.
Thus, the pension payment has little relationship to the total value
created by that employee over their service life.
Grasso's pension exploded when his board decided to award him
a $5 million bonus for restoring stock market functions after the 9/11
attacks. Because of that bonus, Mr.
Grasso was entitled by his pension program to receive more every year in
retirement than he had earned any year prior to that event. These pension surprises are why
corporations are trying to eliminate defined benefit pension programs.
Few economic systems can persist if retirees receive more
value in retirement than they created while they worked.
According to one paper presented in the economic symposium,
boards provide such outsized compensation benefits because they see their task
as responding to management, not protecting shareholder value. Economists call this an agency
As an example, one would assume that the customer at the
hospital is the patient. In fact,
hospitals cannot anticipate patient demand. Instead, they align with doctors, who
will provide a steady stream of patients.
The economic agents to which hospitals respond are doctors, not
Similarly, the argument about board performance is that board
members respond to the CEO, not the shareholder. While boards worry about creating
enterprise value (which they believe they equate to shareholder value), boards
readily dilute shareholder ownership to compensate senior management.
Another paper argued that boards understate the true value of
stock options. The economic cost of
options is the amount of money needed by corporations to repurchase sufficient
shares to avoid share dilution minus the amount paid by option holders to
exercise their option holdings.
Virtually every survey shows that providing incentive pay
rather than stock options for lower levels of management will achieve desired
objectives at a lower cost than distributing the options. Yet, an increasing share of the options
granted has been to the lower echelon, where their actions individually do not
materially alter the value of the company.
The granting of options to the CEO, while not materially a
higher percentage of options granted than in the past, has dramatically altered
In 1970, the base pay of the average CEO in an S & P 500
company was 30 times the pay of the average worker under his employ. Today, that base pay has climbed to 90
times. Management probably is more
difficult today because of the risks and enormous changes presented. While a three fold increase in relative
earnings is large, economic conditions may justify it.
However, total CEO pay, including bonuses and stock options,
was about 40 times the average worker in 1970 but is 350 times today (falling
from the 500 times that was reached at the peak of the stock market). That ten fold gain in relative pay is
much harder to justify.
Requiring companies to expense stock options will make boards
more aware of how much their managers really cost the company. If boards did not know how much they
were giving away (and I truly believe they did not know in the case of Grasso),
expensing will eliminate some of the explosive transfer of wealth from the risk
taking shareholders to the managers.
However, if the problem is one of economic agents, then boards already have an inkling of what the compensation costs and will merely seek alternative ways of transferring wealth to the managers they serve if options are expensed. Frankly, I think some corporate boards suffer from both the lack of cost awareness and the failure to serve their shareholders.