By Christopher Farrell The backlash against lavish executive compensation is growing with good reason. Gargantuan stock-option pay packages. Bountiful pensions. Health care for life. Sweetheart loans. Corporate retirement bennies like free airplane flights, well-appointed apartments, fine wines, and multiple cell phones. The list of executive perks granted the imperial CEO, both in office and out, adds up to an enormous payoff.
In fact, the BusinessWeek executive compensation scoreboard shows that today's average CEO makes around 531 times the average hourly worker's pay, vs. 85 times in 1990, and 42 times in 1980.
WHERE'S THE PAYOFF? There's no economic justification for the record gap. For one thing, a large body of research suggests that from 60% to 70% of the variation in company performance depends on the particular industry in which it operates and the state of the economy, according to Rakesh Khurana, assistant professor at Harvard Business School.
For another, even though much of the dramatic increase in executive compensation over the past decade has been fueled by stupendous stock-option awards, 90% of stock-option plans found in the Standard & Poor's 500 companies don't attach performance conditions to option grants, according to the Corporate Library, a governance watchdog.
"There is an imbalance between unprecedented levels of executive compensation, with little apparent financial downside risk or relationship of this compensation, to long-term company performance," says Peter G. Peterson, chairman of Blackstone Group and co-chair of the Conference Board's Blue Ribbon Commission on Public Trust & Private Enterprise.
WORTHWHILE INITIATIVES. That's a diplomatic understatement by a Wall Street senior statesman. The good news is that stock options are under deep scrutiny. So far, the main flashpoint has been over the expensing of stock options -- their cost charged against profit-and-loss accounts -- to improve corporate disclosure of those grants. The expensing of options appears inevitable, despite fierce opposition from the high-tech community.
Boards of directors also are feeling pressure from advocates of corporate governance to index executive options against a benchmark such as the S&P 500-stock index or the Wilshire 5000-stock index. The idea is to reward managers only to the extent that their strategic investments and tactical decisions beat the market (see BW Online, 4/12/02, "An Answer to the Options Mess").
Both these initiatives are worthwhile. But not enough focus has been put on the real problem with stock options: Too many have gone to senior management and not enough to rank-and-file employees. The National Center of Employee Ownership (NCEO) estimates that between 7 million and 10 million workers now hold stock options. That's a dramatic improvement from the 1 million of the early 1990s (see table).
SPREAD THE WEALTH. Still, outside of the high-tech sector, most option grants go to the upper tiers of senior management. Instead, companies should use options to spread the wealth, recognizing that much of shareholder value in the new economy is created by a corporate culture that values human and intellectual capital throughout the organization.
Ownership creates a sense of belonging, an egalitarian meritocracy that makes a difference every day on the job. Take the suggestive study by Rutgers University scholars Douglas Kruse, Joseph Blasi, Jim Sesil, and Maya Krumova. They looked at productivity performance measured as a ratio of sales per employee, return on assets (ROA), and total shareholder return for a basket of companies before and after instituting a broad-based stock option plan. They also compared those outfits' performance to companies not offering stock options.
In those companies, the post-plan (1995-97) productivity gain was 16% and the ROA 2.5%, when judged against the pre-plan period (1985-87). (The study is available on the NCEO Web site.)
With the coming of expensing and tighter rules, broad-based stock-option plans will reduce reported income and may dilute existing investors' holdings. Yet, with the average grant to top executives about 15 times to 90 times the average grant to nonmanagement employees, the board of directors can cushion the financial blow by reducing outlandish grants to a handful of executives. Shareholders won't suffer if productivity improves and management periodically buys back stock.
TIE THAT BINDS. Yes, CEOs may be able to afford only two vacation homes instead of five, but spreading the wealth is a concrete way for an organization to value the input and ideas of all employees. Says Corey Rosen, executive director of the NCEO: "An ownership benefit ties the management practices together and helps justify the demands an ownership culture makes on people."
The benefits from wider share ownership are societal as well as corporate. "In a capitalist system like ours, based more than ever on free markets and the politics of civic engagement, assets are the coin of the realm," writes Peter Dougherty, senior economics editor at Princeton University Press and author of the forthcoming book, Who's Afraid of Adam Smith?.
"Expanded assets enhance not only economic growth but Adam Smith's treasured civic culture, by strengthening ties across race and class lines, and by giving more people a greater stake, and thus a bigger voice, in the politics of their own communities," writes Dougherty.
In the 1950s, Kenneth Funston, the head of the New York Stock Exchange, promoted the idea that widespread share ownership was Wall Street's answer to communism. But he was ahead of his time with his idea of "People's Capitalism."
NO RETREAT. Wall Street looked at individual investors as expensive "odd-lotters" to be gotten rid of, or, during much of the post-World War II era, as pockets to be picked. Institutional investors, such as corporate pension funds and university endowments, were favored clients. That is, until the rise of the investor class in the 1990s, largely thanks to the advent of retirement savings plans like 401(k)s and IRAs. Today, more than half of America's households own equities.
People's Capitalism has suffered a severe setback, with systemic evidence that crony capitalists on Wall Street, in law and accounting firms, and in corporate boardrooms betrayed the investor class and the working class alike. But retreat is a mistake. Indeed, the pressure for reform is so great today because the investor class is so big.
The most dynamic, flexible companies in an intensely competitive global economy rely on the ideas and energy of all employees. Stock options can be a valuable part of a complete management toolkit for creating a corporate culture that abhors bureaucracy and rewards entrepreneurship. The equity culture revolution is far from finished.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online