Executive Pay - The 'Stock' or 'Share' Option

While superficial trends in corporate culture such as yoga at lunch, the mufti day and palm pilots were being filtered down to us from the United States, so too were American executive pay practices, though in the guise of 'global' practices. The most significant and contentious issue to arise from this has been the use of the 'stock' or 'share' option in senior executive pay packaging.

The Australian Top Executive Remuneration Report, produced by Hewitt, has found that more Australian companies are choosing to incorporate 'at risk' or 'incentive' elements in their executive pay packages, a practice which originated in the US and has now become a global phenomenon.

'Stock' options were introduced to assure the interests of shareholders were aligned to those of the CEO and senior executives. They began to balloon in size and value during the 1980s and consequently became a desirable pay component for senior executives.

In Australia, the introduction of the Fringe Benefits Tax, in 1986, had the largest impact on the structure of executive pay. It meant salary packages would have higher cash components and fewer benefits, with relatively higher rates of performance pay. As a result, companies began awarding executives in the form of cash bonuses and incentives according to job complexity, performance and the market.

Of the 571 companies participating in the CSi Top Executive survey, 66 per cent reported they have share options plans in place for their CEOs and senior executives, while the figure was 45 per cent in 2000. Though an upward trend is visible, it still does not compare with the 98 per cent of the top 200 American companies offering share plans.

Influencing the high incidence of 'at risk' options plans in the US is the fact that such plans are more common amongst multinational organizations, who are based largely in the US. The proportion of long-term incentives to total remuneration cost in a US CEO pay package is 49 per cent, while base salary and short-term incentives account for 22 per cent each.

Despite the increasing occurrence of incentive payments in the Australian executive pay package, the CSi survey found that as a proportion of the total remuneration cost, long-term incentives in the form of share options are decreasing.

In 2000 long-term incentives made up 24 per cent of CEO pay and 17 per cent of senior executive pay. In 2001, these figures decreased to 17 per cent and 14 per cent respectively.

CSi attributes this trend to the volatility of stock options as a remuneration tool as demonstrated by the 'dotcom' crash, the conservatism of companies who have recently introduced long-term incentive plans and smaller awards paid out due to the economic slowdown.

The incidence of short-term incentives amongst Australian organisations has increased slightly for CEO's to 19 per cent for 2001, compared with 17 per cent for 2000. The percentage of senior executive short-term pay has remained static at 15 per cent for the same periods.

What influences executive pay?

For several years now, economic indicators such as inflation have failed to influence the extent of executive pay rises. But today, it seems, with pay supposedly structured to link organisational performance with executive remuneration, there are a number of new factors acting to distort CEO and senior executive pay.

These factors include firstly, the provision of significant premiums to attract top executives to poor performing companies. This has the effect of increasing executive pay despite poor company performance and low shareholder returns.

Secondly, the increasing use of variable elements in the structuring of CEO and senior executive pay, means that during times of strong stock market performance, pay will be skewed upwards, despite real company performance being ordinary or weak.

Rising levels of pay may also be attributed to the 'brain drain' occurring in the Australian marketplace. In order to keep talent, Australian organisations are forced to pay premiums above those associated with organisational performance indicators.

And lastly, the disclosure of executive remuneration has produced both positive and negative effects. The 1986 amendment to the Companies Regulations (Schedule 7) was the catalyst for the disclosure of Australian directors' and senior executive remuneration, followed by changes in 1998 to the Company Law Review Act, which focused on the linking between executive pay and organizational performance.

The positive is that publicly listed companies must provide their shareholders with justification for increases in their executives' fixed remuneration and the criteria for the award of performance pay. The adverse result is what's referred to as the 'domino effect', whereby the disclosure of executive pay acts to focus the attention of top executive compensation on comparative data, instead of company performance.

Though stockmarket indicators are considered the most appropriate measure in terms of CEO performance, in light of the above factors, CSi recommends clients look more closely at industry-specific data and data by company size to determine pay trends.

Options linked to the performance of the company relative to others in its industry are a far better measure of CEO and executive performance, as share prices are generally affected by greater market forces (such as global economic boom or slowdown), not necessarily to do with the industry or real company or individual performance.

Aligning executive pay with the market

Of the 571 organisations participating in CSi's Australian Top Executive Remuneration Report, 87 per cent regarded aligning pay with the market as the most important issue in determining senior executive pay, followed by performance management and incentives. No longer are inflation rates a measure for executive pay increases.

The public versus executive pay rises

History tells us that the public is most angered by excessive amounts of executive pay during times of economic turmoil, high unemployment and company layoffs.

With a current economic climate of company profit downgrades, corporate collapses, increasing national unemployment, and a global economic slowdown, the Australian public, shareholders and the media will be watching 2001 executive pay figures with a critical eye.