Boards and remuneration committees typically issue executive options and their closely related cousins, performance rights or share acquisition rights, as the vehicle of choice for their long-term incentive plans. While the use of equity compensation is generally accepted as being desirable to motivate executives to add value for shareholders, what else it does is not always well understood.
The basic premise behind issuing options and similar vehicles is to encourage:
• the executives to behave more like owners; and
• more risk-taking behaviour from executives – who in theory may be more risk-averse for fear of losing their jobs if most of their pay comes from the fixed remuneration.
However, risk-seeking behaviour could be taken too far by executives who work towards the goals set by the performance hurdles or focus on increasing the share price, often by destroying future value-adding to the firm. With the average tenure of CEOs being only a few years, this type of behaviour is understandable.
In a working paper, Hanlon, Rajgopal & Shevlin (2004) (see HERE) show that stock options do create modest incentives for managers to take risks, measured by future stock and earnings volatility, but are not “consistently associated with positive future performance”. In other words, it is questionable whether stock options are effective tools to motivate executives to add shareholder value in a significant way. There also does not seem to be any evidence that options are truly effective in meeting their original purpose – encouraging executives to be less risk-averse.
This research does not mean that options are inappropriate, but it should be recognised that options are not the only long-term incentive vehicle for executive compensation. Options are effective for certain companies with certain goals, but they are not always ideal for every company. The use of options can be part of a well-balanced executive compensation policy, but boards and remuneration committees should be well aware what kind of behaviour and outcomes they are actually trying to achieve.© Guerdon Associates 2021 Back to all articles