Fortnightly
Bonus Too Small? Here's Why
July 1, 1999
By Charles Cumming
Utility CEOs get more stock options than ever. Too bad they're not tied to dividends.
In 1994, the median total pay package of a $1 billion to $5 billion revenue utility CEO was
only about 51 percent of his counterpart in general industry. By 1997, this gap in CEO pay had
worsened, dropping to 49 percent. So why does executive compensation in the utility industry
continue to lag behind pay in general industry?
While the effects of deregulation play a role, lagging pay also is due to the expanding use of
stock options at all types of U.S. companies, and the characteristics of typical utility's
stock. While the prevalence of equity-based, long-term incentive plans has increased within
the utility industry, the value of those plans has trailed that of the typical general
industrial CEO.
Between 1994 and 1997, the average long-term incentive portion of the typical compensation
package for general industry CEOs grew by $640,000, as shown in table 1. That amount is more
than twice the $295,000 increase for utility CEOs. This difference is the primary reason
utility executive pay has not begun to catch up to general industry standards.
The percentage of utilities granting stock options to their top executives rose from 57 percent
to 76 percent between 1994 and 1997. The idea behind granting stock options is to link
executive interests directly to shareholder interests. However, in an industry where a
significant portion of total shareholder returns comes from dividends, the logic is suspect.
During the past five years, the average TSR in the utility industry has been 11.8 percent,
with nearly half of this amount coming from dividends. If stock price appreciation in the
utility industry can be expected to equal only half that of general industry, then the number
of options that would have to be granted to generate the same level of long-term incentive
opportunity would need to be doubled.
Such a strategy likely could not be sustained. The reason is that the amount of stock that
would be granted, as a percentage of the total shares outstanding (i.e., the dilution, or
"overhang"), would begin to exceed standards that institutional shareholders view as reasonable
and prudent--typically 10 percent to 13 percent. As shown in table 2, the percent of common
shares outstanding that utilities have reserved for outstanding stock grants to employees is
less than one-third of the level in general industry. And although the proportion of CSO
reserved by utilities for future grants has moved closer to general industry levels, it is
obvious that these plans will generate far lower long-term incentive payoffs for the
foreseeable future.
Consider net present value as well. A common method of estimating the value of a stock option
grant is to compute the present value of the expected future stock price appreciation using
the Black-Scholes option-pricing model. The typical Black-Scholes ratio of a utility option
value compared with the market price of the stock at the time of grant is roughly 40 percent
of the typical general industrial BS ratio (15 percent vs. 35 to 40 percent). So an option
grant to a utility executive that has the same face value at time of grant as a grant to a
general industrial executive can be expected to generate only about 40 percent of the actual
long-term incentive payment.
There are several ways to offer more competitive long-term incentive opportunities while still
employing company stock:
Attach dividend equivalents to the option grants.
Use performance-based restricted stock or performance shares in addition to option grants.
Provide executives with a choice of receiving their long-term incentive payouts in cash or
discounted stock, where the total award value would be higher if the latter were chosen.
Provide for acceleration of option vesting if financial performance targets are met.
If the executive pay gap doesn't close at a greater pace than seen in the past three years,
utilities that have undertaken diversification programs may experience difficulties in
competing with more experienced competitors in the new industries in which they are trying
to establish a foothold.
Author:
Charles M. Cumming is a Philadelphia-based executive compensation consultant with William M.
Mercer Inc. He assists utilities in the design and implementation of managerial reward
programs.
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