Better Options

Disillusioned investors are demanding stronger links between executive pay and long-term performance.

Avery Dennison Corp. sticks to what works — not just in its business, but also in its executive compensation. The adhesive-products company has pointedly not abandoned its stock-option program, despite the recent exodus from options by many other companies. Instead, Avery Dennison adheres to an options-based pay package that rewards performance and reassures investors — no small feat these days.

Why aren’t investors railing against the options program at Avery Dennison? For starters, its stock options are performance-based. Executives can cash in after three years — but only if the company outperforms two-thirds of its industry peers on return on total capital. Otherwise, the options vest in 9.9 years, at a fixed exercise price. Either way, Avery Dennison doesn’t have to expense them, thanks to the fixed price and original vesting schedule.

But performance-based options aren’t the whole story. The company’s long-term executive comp plan also includes a cash-bonus system based on division-specific goals, ranging from economic value added to earnings growth. Avery Dennison hasn’t fallen into the trap of relying exclusively on options to compensate executives. “We’ve been very conservative with our program,” says CFO Daniel R. O’Bryant. “We don’t have management making tens of millions on options. I don’t think we have a problem to solve here.” Given Avery Dennison’s strong earnings and stable stock price during the past three tumultuous years, no wonder O’Bryant is calm heading into this year’s annual-meeting season.

Other CFOs wish they could be so relaxed. More governance-related shareholder proposals (more than 700) have been filed so far this year than in any previous entire one-year period, and 45 percent of those proposals targeted — surprise — executive-compensation matters. A recent Hewitt Associates study found that as a result of this intense shareholder pressure, 18 percent of companies have converted, or are planning to convert, their long-term incentive plans from stock options to more-palatable vehicles, such as restricted stock, performance-based options, or outright stock grants.

Moving away from traditional stock options is generally seen as a good thing by shareholder activists, who view them as a primary cause of corporate malfeasance. And if the Financial Accounting Standards Board succeeds in its renewed effort to require that options be expensed, the chief economic rationale for them will disappear. The question is, what are the alternatives to options — and how effective will they be?

Predictions, as Yogi Berra said, are difficult to make, especially about the future. Stock options were initially hailed as a good way to align executive and shareholder interests, but instead seemed to encourage executives to manage for short-term stock-price gains. Restricted stock is making a comeback, but many compensation experts are dubious about its effectiveness. One thing is clear, though: as new scandals emerge, and as the stock market slump continues, investors are in no mood to tolerate the options status quo. They want their companies to do something different-and better.

CFO magazine talked to CFOs of three companies — Avery Dennison, Progressive Corp., and Sealed Air Corp. — that are trying something other than traditional stock options in their incentive-pay schemes. We also asked compensation experts for their advice on what works. There is still a place for options, they say — so long as they reward executives for superior performance, not just for enjoying the ride in a bull market. And all agree that incentive plans should have the goal that Avery Dennison expressed in a recent proxy statement: “to promote the creation of stockholder value over the long-term.”

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