The Impact of Performance-based Compensation

Upon researching the current affairs regarding performance related pay, and lucrative remuneration packages, I discovered this example of where excessive performance pay was actually inhibiting the recovery progress of American airline, US Airways. The US Airways pilots’ union is advising its members to vote against a stock incentive plan that would further compensate three of the carrier’s senior executives who next month may qualify for a severance package valued at a total of $45 million.

Roy Freundlich, communications officer for the Air Line Pilots Assn. (ALPA) local, said the recent revelations of the “exorbitant” levels of compensation had destroyed the credibility of the three executives’ plan to restore the carrier after the failure of the proposed merger between US Airways and United Airlines. ‘Now they expect employees to endorse their plan that degrades our company and places regional jets in the mainline carrier,’ he said. (Executive Pay Clouds Airways Recovery, James Ott, Aviation Week, September 2001)

This is clearly, a very negative example of bonuses impeding organisational performance as a whole, the complete opposite of the supposed objective. This example is mainly due to conflicts between the board and senior executive regarding the agreed specification of their remuneration package. This problem could have been prevented through better transparency of remuneration packages for corporate managers. Although, recent accounting standards have forced companies to provide details in their accounts – thus facilitating a more informed shareholder unit.

Hall and Murphy (2003) suggest that this form of bonus is an inefficient and expensive way to compensate employees. Other hidden costs associated with stock options for the employees include the fact that they can’t be sold, if the company share price drops below the employee purchase price for the shares then the employee stock options become worthless, cash usually needs to be paid to buy shares when exercising employee stock options, if working for a private company, employee stock options granted can be difficult to put a value to, due to long vesting periods, benefits are not immediately visible to the employee and if you decide to leave the company during a vesting period the you lose your employee stock options.

On the other hand, employee stock options can also have negative impacts on the company issuing the options to their employees. For instance; a decline in the value of stock options may decrease employee motivation, there may be objection of investors in the company in apparent dilution of their shares and as Fortune magazine has pointed out the incentive is lopsided as it rewards price increases but does not penalize the opposite giving managers incentive to take undue risk. These drawbacks have led to the shift away from stock options in firms such as General Electricity and Microsoft, which have announced that they will no longer use stock options to compensate their CEO’s.

To conclude, stock options are currently widely adopted within many executive compensation packages as an incentive to increase the value of the firm. However, there are many other reasons firms choose to use stock options. In order for a company to wreak the benefits from this incentive plan the advantages must of course outweigh the drawbacks mentioned in this discussion. Close attention must be paid to the design of stock options in order to achieve optimal benefits from the implementation of employee stock option.

Stock options seem to work best for small companies where future growth is expected and for publicly owned companies who want to offer some degree of company ownership to employees. Important aspects that should be considered when implementing stock options include; how much stock a company will be willing to sell? who will be receiving the options? how many options are available to be sold in the future? and is this a permanent part of the benefit plan or just an incentive?

References:

Burns and Kedia, The Impact of Performance-based Compensation on Misreporting, Journal of Financial Economics 79 (2006), pp. 35-67

Hall B and Murphy K, The trouble with stock options, Journal of Economic Perspectives 17 (2003), pp. 49-70