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Saturday, June 10, 2006

Free Lunch for Executives?

I don't understand this argument from the NRO attempting to justify high pay for CEOs. Here's how it works. You are the CEO of a company but instead of paying you in cash, the company gives you an option to buy, say, 1,000 shares of stock any time during the next ten years at the current $100 price ($100,000 total). Over the next ten years, suppose the price of the stock increases to $250 so the 1,000 shares are worth $250,000 and the CEO exercises the option at the end of the ten year period.

The easiest way to think about this is to imagine the company going out and buying the stock on the market at $250 per share at the end of the ten year period (if it purchased them in the past, the $250 is still the opportunity cost). Since the company receives $100 per share from the CEO, the option price, the company loses $150 per share, or $150,000. The argument is that "compensating [CEOs] ... has not come at the expense of company profits." Where do the writers of this commentary think the money comes from if it isn't from the company's bottom line?:

Executive Compensation Revisited Politicians decrying “excessive” CEO pay ignore the incentive basis that drives corporate success, by Thomas E. Nugent & Robert F. Clarke, Commentary, NRO: A few Congressional leaders have nothing better to do than pursue the decision by corporations to “pay” hard-working executives for their contributions to their respective companies. The latest brouhaha involves the retired chairman of Exxon Mobil, Lee Raymond, and his “excessive” pension payment of $98.4 million. This compensation was on top of a $69.7 million compensation package for 2005.

What the press reports, but fails to explain, is that ... only a minor amount of this “compensation” comes out of company funds. According to a Wall Street Journal article that reported these payment statistics, most of Raymond’s 2005 compensation was made up of restricted-stock awards and the exercise of options. In other words, compensating Raymond, in large part, has not come at the expense of company profits.

Very often CEO compensation is broken down into salary, bonus, and grants. For the sake of argument, since we don’t know the exact breakout of payments to Raymond, here’s a sample of how a CEO could have been compensated at Raymond’s level for 2005:

  • Salary: $2.5 million
  • Bonus: $10 million (based on good company performance that year)
  • Grants of Restricted Stock and Stock Options: $57.2 million

On this last point, options are typically granted from time to time at an exercise price equal to the market price of the stock on the date of the grant. At some point (often after 10 years), the options must be exercised, or they will be forfeited. At the time of exercise, any gain in the shares above the exercise price is taxable to the CEO as ordinary income...

In this example, the company paid the CEO a total of $12.5 million — not $69.7 million. The $57.2 million difference is a gain in the value of the shares earned by this CEO’s stewardship of the company...

The government’s selective intrusion into the private sector to judge what a fair compensation package should be ignores the incentive basis that drives corporate success. ... Once we let the political camel’s nose under the free-market tent, we may find that everybody’s compensation — except, of course, that of the politicians — will have to be approved by a “fairness” committee created by the federal bureaucrats.

It would be nice if CEOs could be paid with free lunches, the NRO seems to have quite a taste for them in tax cut and Social Security proposals and now in CEO pay, but it doesn't work that way.

Update: As pgl at Angry Bear notes, I oversimplified this example by having the firm hold the option and absorb all risk, there is no alternative risk-free asset, etc. in an attempt to make the result transparent. More generally, the firm can purchase an option contract from a dealer and pay the price given by Black-Scholes formula (I should have noted this - I calculated the ex-post loss, not the price of the option ex-ante - either way, as pgl notes, there is no free lunch).

Update: Brad DeLong contributes to the discussion.

    Posted by on Saturday, June 10, 2006 at 11:00 AM in Economics, Income Distribution | Permalink  TrackBack (0)  Comments (26)


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