THE STOCK market's plunge has hit one group of American workers especially hard. Its members made less money -- a lot less -- last year than the year before. But their story, even when it is known, will not move many people to tears or donations.
The group in question? The top managers of America's largest corporations. They stand to lose so much from the market's woes because so much of their compensation now comes in the form of stock options, stock appreciation rights, and other stock-price-related devices. What has happened to them tells us much about how -- as well as how much -- American executives are paid and, so the theory goes, motivated. It also suggests that some changes may be in order.
Let's start with how and how much. In most U.S. firms, the pay received by the management team is geared to the chief executive's compensation; as his or her pay package moves up or, more rarely, down, so too does the compensation of other senior managers. So looking at the compensation of CEO's can give us a good indication of trends in compensation for senior managers as a group.
Stock-price-related compensation plans have become a near-standard feature of executive compensation in corporate America: About 90 percent of top management in the nation's largest firms participate in such plans. Moreover, the amounts involved are very substantial. While most executives don't take their profits in any given year, Forbes magazine's analysis of the 1986 compensation of 800 CEO's found that 32.5 percent reported realized profits from stock-price-related plans worth, on average, close to 75 percent of salary and bonus. (The executives received an average $750,000 in salary and bonus in 1986 and stock-price-related profits of $560,000; the corresponding figures in 1985 were $683,900 and $481,000.)
With so much money -- and so high a proportion of their compensation -- on the line,executives clearly had a lot to lose in the market's nosedive. What may not be so clear is how the combination of these two factors -- the importance of stock-price-related devices in executive compensation and the recent drop in stock prices -- threatens to distort pay patterns for, and create divisiveness in, the executive groups in many U.S. companies.
Executives at the same level in a firm -- for example, two senior vice presidents with comparable responsibilities -- may have received their stock options or stock appreciation rights at different times and different prices. Executive A, who was granted options years ago at relatively low prices, may still be in position to profit handsomely from those options even after the market crash. Executive B, whose options are of more recent vintage, may find his or her shares substantially underwater -- that is, the stock price on the open market is below the price at which the options allow him or her to buy.
This kind of disparity can create serious problems of equity and morale. Older executives are typically the ones granted stock options at lower prices; younger managers are more likely to have received their options at higher prices. Those in the latter group, who represent the future of their firms, may feel unfairly treated with respect to what is, after all, probably a large portion of their potential compensation.
If the market's steep drop presages a longer-term decline or several years of flat prices, senior executives in many corporations will be divided for some time to come into two classes: those who made a bundle on their stock options during the glory days of the bull market and those who suffered when the boom was over. And if there are any doubts about whether this schism will create resentment, it should be noted that some of the bundles made were very large.
The five-year upward march of share prices led corporations to rely more heavily on stock-price-related compensation programs, in the apparent belief that large grants of stock options and stock appreciation rights would not cost much because the rising market would pay for them. Some firms were, frankly, profligate in awarding this sort of ostensibly cut-rate compensation. There is no question but that literally thousands of executives became millionaires during the market's climb -- and many of these in companies that were not really performing well.
When stock-price-related plans came into currency in the late 1950s, they were intended to serve as incentives for executives to build, and manage well, the firms that employed them. The theory underlying these plans was that if executives were granted long-term ownership stakes in their companies, they would be especially assiduous in furthering shareholder interests. The end of the bull market forces us to face up to the fact that stock options, stock appreciation rights, and other stock-price-related devices are no longer doing the motivational job for which they were intended. This is so for two reasons.
First, stock-price-related plans have come to function increasingly not as mechanisms for giving executives long-term ownership positions, but as elements of short-term compensation. When executives exercise stock options and then immediately sell their shares, they build current income, not enduring equity. Stock-price-related plans were meant to generate lasting loyalties and commitments; practice has been departing from theory.
Second, the experience of the past five years suggests that in any event, the linkage between stock-price-related plans and the incentives for individual managers is much weaker than had been supposed. Between the summer of 1982 and the fall of 1987, the Dow-Jones Industrial Average rose from about 770 to over 2700. Over that same period, the price-earnings ratio of the stock market as a whole moved from six to 22; in other words, in 1987 the market was willing to pay an average of more than three times what it paid in 1982 for a dollar of earnings.
For most executives, these massive shifts in market behavior meant that their stock options increased rapidly in value even without any special efforts on their part. Similarly, when the market dropped sharply, extraordinarily effective managers were hurt along with their less productive colleagues.
In many large public companies, stock options granted executives over the last several decades have cumulated to more than 20 percent of currently outstanding shares. This means that the relative ownership position of outsiders holding stock has been eroded. But there is no credible evidence that the companies have benefited from better management.
During the stock market's remarkable five-year climb, stock-price-related devices were an enormous boon to executives -- and no great bargain for the firms that employed them. Now, in the wake of the market's crash, is the time for companies to reconsider the role of these devices in the compensation of their managers.
Arch Patton is a retired director of McKinsey & Company, the consulting firm.