Better Options for CEO Pay

Stock options have a bad rep today. The reasons are many, and some of them are valid. As the primary vehicle for compensating executives at publicly traded firms, they are blamed for the outrageously excessive pay of U.S. companies' chief executives. And far below the executive suite, options have made instant millionaires of many untested young employees whose main accomplishment was getting hired by a business whose shares soared when it went public. Now we've learned, from the back-dating scandal, that many companies were rigging the options game for years, effectively eliminating much of the uncertainty over whether a recipient would be able to exercise the options for a profit.

Reform and expand

No wonder some critics say that the use of stock options in corporate America should be reduced or eliminated. But that's the wrong way to go. Instead, we should reform stock options -- and offer them to every employee of a public company.

Stock options for senior executives are virtually universal, but woefully few publicly traded companies (an estimated 15% to 20%) make options available to most or all of their employees. The list of the ones that do includes many successful large corporations in many sectors, including Cisco Systems, PepsiCo, Procter Gamble, Southwest Airlines, Starbucks, Walgreen Co. and Whole Foods Market.

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Why should shareholders encourage granting options to every employee, even though doing so would entail some short-term dilution of their stake in a company? Because "we know that sharing equity broadly with employees seems to improve corporate performance," says Corey Rosen, executive director of the National Center for Employee Ownership (http://nceo.org).

Here are three badly needed stock-option reforms:

Reduce senior-executive options to a small fraction of the total grants awarded to all employees. It is a fallacy that senior management is solely responsible for a company's success. Good ideas come from every level, and the providers of those ideas should be rewarded.

Whole Foods, the grocery chain, boasts that more than 90% of its options are granted to rank-and-file employees. Also, no executive's pay may exceed 14 times the average earnings of all its employees (CEOs at many other billion-dollar corporations are paid 200 times average employee earnings).

Make option grants conditional on the company's outperforming its industry peers. CEOs should not get rich simply because a rising tide lifted their leaky boat.

Lengthen the vesting period on the exercise of option rights in order to give employees incentives to stick around and focus on long-term goals.

Stock options aren't the only means of developing an ownership culture among all employees. Annual profit-sharing works well, too, especially if the year-end distribution represents the same percentage of everyone's salary, from CEO to clerical workers.

The ESOP solution

My favorite device is the employee stock ownership plan, or ESOP. ESOPs are created when owners either give or sell (often on credit) a large chunk of company stock to their employees, who own the shares collectively and cash out only when they leave the company.

There are more than 9,000 ESOPs and similar plans in the U.S. Rosen estimates that employees hold the majority of shares in about 35% of them, including W.L. Gore, Graybar Electric, Davey Tree Expert, U.S. Sugar, and supermarket chains Hy-Vee, Price Chopper and Publix.

Giving all workers a tangible stake in their employer's success is good business, good social policy and the right antidote for excessive executive pay.

Columnist Knight Kiplinger is editor in chief of Kiplinger's Personal Finance and of The Kiplinger Letter and Kiplinger.com.