Whither the stock option? While stock options lose more luster as executive motivators, compensation committees face challenges, including selecting other forms of stock incentives.

During the late 1990s, companies issued billions of dollars worth of stock options to motivate their employees. Those days are likely over, for a variety of reasons, including potential new rules requiring companies to expense them. But getting the best out of executives through other forms of stock incentives--including actual ownership--will no doubt continue, according to a recent study of executive compensation conducted by Watson Wyatt.

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Indeed, stock options' best days may be behind them--not just because they will soon have to be expensed, but because institutional investors are increasingly worried about them. Moreover, there is perennial concern over perceptions of excessive CEO pay and disconnects between pay and performance. Finally, there is the crisis in governance created by corporate accounting standards and a gap between the cost and value of options created when a company's future accounting cost of stock options exceeds their value to employees.

These factors do not appear to be lessening in importance and have already resulted in a huge drop in the value of options granted to employees. From 2001 to 2002, the value of stock option grants at major companies fell by 29 percent, from $139.6 billion to $99.6 billion.

When data for 2003 becomes available, it will likely show a further decline of 10 percent to 15 percent from 2002. The magnitude of this drop cannot be overstated: the only other event in the history of executive compensation as important is the sharp increase in executive pay levels that took place during the 1990s. However, the recent bull market has softened this trend, as 2004 values are expected to be up from 2003.

Some analysts believe that the decline in option value was caused entirely by stock price declines--for example, a company granting one million stock options at $30 in 2001 and one million at $20 in 2002. Other things being equal, their value would have declined by 33 percent, solely due to stock price movement. But this is not what happened. In fact, declines in both stock price and the number of stock options granted are responsible.

For the average company, the 29 percent total decline in stock options value cited above came about as a result of a 20 percent decline in the average number of stock options granted to all employees, from 7.6 million to 6.1 million, and a 16 percent decline in the average value per option, from $17.25 to $14.50, almost entirely due to stock prices falling.

Options Reflected in Stock Prices

Consistent with findings in a prior study, investors consider stock option expenses as real expenses, even if reported only in the footnotes. As expected for a bear market year, the relationship was negative: those with the highest option expenses in 2002 had the lowest total returns to shareholders (stock price appreciation plus dividends). Dividing up the 998 major companies in the recent Watson Wyatt study into three groups, the companies with the lowest option expenses--those with a 2002 expense of $266 per employee--had total return of negative 4.3 percent. Those in the highest expense group, with a 2002 expense of $3,997 per employee, had a total return of negative 12.4 percent (see Figure 1).

Pay and Performance Linked

Another important finding is that pay and performance are strongly linked. Analysis shows a strong, positive relationship between company performance and executive compensation levels. For example, companies whose CEOs had higher total pay opportunities from 1998 to 2002, as measured by their total direct compensation over the five years, had higher total returns to shareholders during the period than those with CEOs having lower pay opportunities. The relationship between pay and performance is apparent in other measures as well:

* Annual increases in a CEO's total cash compensation are positively related to the company's stock performance.

* CEOs of companies that performed below a one-year total return to shareholders median had a decline in actual pay and stock option profits in 2002.

* Companies having CEOs with high stock ownership were superior investments compared to those with low ownership. Companies with high CEO ownership realized a three-year median total return of 3.9 percent for their shareholders for the period ending December 2002, while low CEO ownership companies saw a return of negative 3.4 percent on their investment during the period.

* Investors are willing to pay a premium for companies where senior management and shareholder interests are aligned.

Stock Option Overhang Declining

Stock option overhang has continued to grow--despite efforts by a large number of firms to reduce their overhang levels between 2001 and 2002--primarily from a large reduction in the amount of options being exercised. Stock option overhang is a measure of potential dilution from granted and approved stock option programs (calculated as options granted and outstanding, plus shares that remain to be granted, expressed as a percentage of total shares outstanding). The average stock option overhang increased one-half percentage point over the average of the same time last year--from 15.6 percent in 2001 to 16.1 percent in 2002 for companies with December 2002 year-ends.

However, there is strong evidence of a decline in the growth rate of overhang during this same period. Between 1997 and 1999, overhang levels increased at an annual rate of 11.8 percent, while growth slowed to 7.9 percent between 1999 and 2002. Moreover, the earlier growth occurred as a result of larger option grants and more extensive programs covering more employees during a bull market. The current increase can be attributed to fewer options being exercised as they are increasingly out of the money (worth more than the current price of the stock), due to declining share prices without an offsetting decline in new share authorizations.

There are substantial differences in overhang levels by industry (see Figure 2). Technology and health care firms have consistently exhibited higher overhang levels than other industries, while utilities have exhibited the lowest levels of overhang. This is consistent with economic theory, which predicts that stock-based incentive compensation is more important in industries with a high share of value derived from intellectual property.

The study also found that firms with higher overhang levels have more options outstanding and higher run rates (a measure of shares granted annually to employees, which are calculated as options granted and expressed as a percentage of total shares outstanding).

Stock market observers have argued that total overhang is less important to shareholders as a measure of potential dilution than the number of options granted. They suggest that shareholders put less emphasis on potential dilution from options remaining--because boards can reduce or eliminate future grants--and more on those already granted. But analysis shows that investors are quite concerned about total overhang, and assume that all options authorized will be granted eventually. This insight will be even more important going forward as proposed accounting rules will place more weight on options remaining to be granted than on options granted.

Possible Solutions

Compensation committees face several challenges in the stock option arena, primarily the impending need to expense options. But they also need to deal with already high levels of overhang and out-of-the-money options. These and other issues, including excessive dilution, suggest that options will account for a smaller share of total compensation. Going forward, companies may substitute options with direct stock ownership, restricted stock grants and other forms of compensation, which could be more shareholder-friendly and just as motivating.

Companies should consider the following alternatives:

* Using a portfolio of stock incentives--including restricted stock, performance shares and stock purchase plans. These vehicles can be used to substitute for or reduce traditional stock option grants.

* Evaluating grant sizes very carefully. Especially for top management, grants are probably already large enough to be motivational.

* Creating more direct stock ownership. Real stock ownership has certain advantages over options, including influence on retention and changing behaviors. The study suggests that high executive stock ownership, unlike overhang, yields superior returns to shareholders.

* Requiring executives and directors to announce their intention to sell stock before the sale and to disclose the sale afterward.

* Encouraging the compensation committee to retain its own independent advisors on stock option and executive compensation issues.

A good example of how to incorporate these suggestions is to create a management stock purchase plan (MSPP). An MSPP is a cost-effective way to encourage stock ownership by allowing executives to purchase company stock (with matching shares) on a pretax basis from income that would otherwise be paid as base salary or bonus. The advantages of an MSPP to the employer are that restricted stock has predictable and controllable accounting costs. The extra cost is equal to the match at purchase, and it is spread over the restriction period. In addition, there are tax advantages to the employer.

Purchases can be mandatory, voluntary or a combination of the two, depending on factors such as executive stock ownership levels and firm culture. Companies typically offer a 25 to 50 percent match, which appeals to executives and shareholders. Typical plan features include:

Eligibility -- limited to designated members of senior management.

Match -- a 25 percent match on the fair market value on the date of purchase.

Mandatory purchase -- participants could be required to use 25 percent of their bonus to purchase restricted stock.

Voluntary purchase -- participants are usually allowed to make voluntary purchases beyond mandatory levels.

Restriction/vesting -- purchases are usually restricted from sale for a period of three years.

Certainly, an MSPP is not appropriate for every company. Each needs to seek its own balance based on strategy, culture and history. What is universal is the need for companies to determine equal or better ways of motivating executives--given the diminished importance of options--or else face the consequences: poorer performance and angry shareholders.

Figure 1: Shareholders Take Options into Account

                                       2002 Total
2002       2002 Expense     Total      Return
Expense    per Employee     Expense    to Shareholders

Low          $266            $3.4M      -4.3%
Medium       $727            $8.1M      -9.0%
High       $3,997           $16.0M     -12.4%

Figure 2: Disparate Overhang Rates by Industry

Industry                      2001      2002     Change

Energy                        10.6%     10.7%     1.7%
Materials                     13.1%     13.5%     2.8%
Industrials                   14.7%     15.2%     3.1%
Consumer Discretionary        15.9%     16.1%     1.1%
Consumer Staples              12.7%     12.8%     1.2%
Health Care                   17.2%     17.6%     2.1%
Financial                     12.6%     13.7%     8.3%
Information Technology        24.6%     25.1%     1.9%
Telecommunications             9.6%     10.4%     9.3%
Utilities                      6.4%      7.7%    21.2%
All firms                     15.6%     16.1%     3.4%

Ira Kay is Director of Compensation Consulting at Watson Wyatt Worldwide (www.watsonwyatt.com). He can be reached at [e-mail].