Upfront: Stock Options Down but Not Out

Although stock-option grants have become more costly since expensing them was mandated, they still might be a good deal.

Since the FASB and the International Accounting Standards Board mandated expensing of stock options, companies have been relying less on stock-option grants in their executive compensation plans. A June report by Watson Wyatt Worldwide finds that the number of stock options awarded to CEOs declined 16 percent this year, accelerating 2004's 7 percent decline. And a July survey by Towers Perrin reveals that a little more than half of respondents have begun using a mix of stock-option grants and restricted stock.

But it may be a mistake to cut back stock-option grants, says Jack Dolmat-Connell, president of compensation and benefits consulting firm DolmatConnell & Partners Inc., in Waltham, Mass. "Options, if not overused, are actually a really good pay-for-performance vehicle," he says. "The only way to make money on an option is to increase the share price."

Before FAS 123 (R) was handed down, "options were free," he notes. "And because they were free, annual grant rates got up there pretty significantly. Companies are having to manage those back because of shareholder pressure, and one of the ways of doing it is to move to restricted shares.

"But restricted shares definitely have some downsides," Dolmat-Connell cautions. "Five years ago they were the black sheep of the long-term incentive family, with no strong link to performance, no downside [for the executive]."

A recent study by Dolmat-Connell's firm suggests that stock-option grants may be superior to restricted stock in boosting companies' performance. It shows that high-performing companies are 64 percent more likely than low-performing businesses to grant stock options to their CEOs as the only long-term incentive and are 39 percent less likely to grant restricted stock.