Finance chiefs bristle at being characterized as “bean counters” as if it were a bad college nickname. They’d rather be known as leaders, whether that means being strategists, business partners, or the chief executive’s right hand. But a new study suggests that employers tend to rely less on stock options—and save money on compensation costs—when CFOs are strongly supervised by a board finance committee or a CEO with a finance background.
Released in February and headed by a professor at the University of Oregon’s Lundquist College of Business, the study comes during an uncertain time for the future of the once-mighty stock option. With mandatory expensing of options coming, options compensation itself it going – at least at many companies. Dell, Whole Foods, Pfizer, and others are significantly cutting back on option grants, in some cases replacing them with performance-based cash awards. On February 19, The New York Times reported that as many as 40 percent of public companies, according to a study, are reconsidering their option plans; up to a third may discontinue them over the next few years.
Most of those companies are still granting options to executives. But companies are rethinking executive stock options too. An April 2004 study by Mercer Human Resource Consulting showed that stock-option pay among CEOs of the 350 largest public companies was down 5 percent in 2003 from the previous year.
The conventional wisdom about the benefit of stock-option compensation is that it’s the carrot that elicits the best possible performance from executives by boosting their personal stake in the company’s performance. According to the Mercer survey, even with option compensation at a five-year low in 2003, options were still 63 percent of total CEO pay packages. As carrots go, options are the biggest crop in the garden. But what if companies didn’t need the carrot?
As compensation committees debate whether and how to rein in the use of options, the Lundquist study suggests a way to reduce the reliance on incentive pay overall: monitoring of the CFO’s decisions either by a finance subcommittee of the board or by a finance-savvy CEO.
In the study of 1,126 finance chiefs and their compensation from 1993 to 2001, stock-option pay was lower among CFOs at companies with a finance committee by about 13 percent. At companies where the CEO had financial expertise, there was a decrease in the CFO’s incentive pay of about 11 percent.
Professor Steve Matsunaga, the study’s head author, explains the correlation between monitoring and reduced reliance on incentive pay this way: One method for a company to insure that its CFO is making the best choices for the company is stock options. Suppose a CFO must make some decisions about company investments. In theory, since CFOs know that the payoffs from a sound decision will go into their personal wealth, they’ll make the best decisions they can.
Another way to insure the best decision, however, is monitoring the CFO. The finance committee or CEO with financial expertise can either direct the CFO’s corporate investment decision or address a poor decision during a performance evaluation.
In the second case, monitoring enables the company to observe and understand the CFO’s activities – and step in to prevent mistakes. The company can, in turn, pay the CFO cash because it has removed the uncertainty about whether the CFO will perform his or her best. That, of course, is what stock options are designed to insure. “If I knew more about what the CFO is doing,” says Matsunaga, “I can pay him cash” instead of incentive options because finance is less of a black box.
CFOs reading this might be ready to have Matsunaga’s head over the possibly insulting implications of the hypothesis. Do finance chiefs need to be micromanaged via their compensation? Are they untrustworthy in terms of making the best decision? Matsunaga chuckles at the notion of ruffling feathers. “If you trust the CFO to make the best decision,” he notes, “then there wouldn’t be incentive pay.”
The hypothesis about monitoring could be true of any C-level executive, he adds. Perhaps a chief marketing officer would be paid less in stock options if the CEO had a marketing background and could monitor that executive, for example.
There’s another argument for use of stock options than its use as a way to improve company performance, though: talent attraction and retention. Matsunaga argues, however, that CFOs are most often paid at the market level; the question is, how much of each component makes up for the whole pay package? Where there’s less emphasis on options, a higher base salary might be offered, for instance.
“Options are a costly way of attracting talent; they are risky, so you have to give more than if you give cash compensation,” says Matsunaga.
In the end, as with everything else, moderation is key. “We would expect that the best compensation package would be a mix of monitoring and incentive pay,” says Matsunaga.