It’s Time for All Employees to Get Stock Options

Something is rotten in corporate America, and even the owners are complaining. A handful of pension funds voted against reappointment of AT&T; board members last week to protest Chairman Robert Allen’s $16-million pay package.

“The compensation package is outrageous” given the company’s “mediocre performance,” said William Crist, president of the California Public Employees’ Retirement System, or CalPERS, the nation’s largest public pension fund.

Even though the protest had little effect--holders of 94% of AT&T; voted to support the board--it was symbolic of rising discontent with the corporate system, especially its effects on ordinary employees.

The problem is profound, but so are the changes coming to U.S. corporations. A good bet is that within a few years we’ll see companies routinely granting stock options for all employees, not just top managers. It’s a move that has a sound philosophical underpinning and represents a way to cope with change and uncertainty while creating an advanced, competitive economy.

But before we can understand the cure, we should review symptoms of the disease.

The pay gap is well-known. Top executive incomes, stoked by a rising stock market, have been growing more than 10% a year while other employees live with small if any pay raises and mounting job insecurity.

Also, “there is a significant gap between returns to shareholders and returns to employees,” says Frederic W. Cook, a compensation consultant. “Since 1981, the average shareholder return has been 17% a year, while the average annual increase in employee pay and benefits has been 4%.”

Cook understands that employees share some of those stock gains through their pension funds, employee stock ownership programs and mutual funds.

But the gains to employees are mostly unseen and indirect while those to top managers are cashable and immediate--and often a particular affront when stock prices rise as a result of layoffs.

It’s a situation many feel has to change. Labor Secretary Robert Reich last week called on corporations to “allow workers to share the gain as well as the pain.”

Stock options are the way to do that. PepsiCo Inc. already grants all its employees stock options equal to 10% of their previous year’s pay. Employees can exercise the options over the following five to 10 years. And every year they earn more options.

PepsiCo has been doing that since 1989. Its profit has more than doubled and its stock price has nearly tripled in that time. And company employment, thanks partly to acquisitions, has grown from 150,000 to 481,000.

The purpose of the program is “to align employee interests with those of shareholders,” says PepsiCo spokeswoman Elaine Franklin, echoing the late Alfred P. Sloan of General Motors, who used those very words in originating stock options in the 1920s.

The program has special meaning for PepsiCo, since it wants to give incentives to personnel who interact with the public at Taco Bell, Pizza Hut and Kentucky Fried Chicken restaurants, and while delivering and selling Pepsi-Cola and Frito-Lay products.

Options at PepsiCo are used as incentives, on top of base pay. But options can be an integral part of pay, explains Margaret M. Blair, author of “Ownership and Control, Rethinking Corporate Governance for the 21st Century” and other books on the corporation.

To Blair, a scholar at Brookings Institution, the belief that shareholder value resides only with holders of company stock is incomplete. The experience and skills an employee gains through years on the job are part of the company’s human capital and constitute the employee’s equity stake.

Furthermore, the risk to that equity is quantifiable. If an employee loses his or her job, Blair says, the pay at the next job, on average, will be 25% lower.

At least part of that 25% represents the employee’s productivity, due to experience and skills, at his or her old company, Blair argues.

That’s important to keep in mind as big companies lay off employees and boast that the savings have increased shareholder value. The companies are not actually increasing value but transferring it from one holder to another. The added shareholder value, in short, comes at the employee’s expense.

And that’s at the heart of the problem in corporate America today, as rage and threats of legislation grow in Washington and around the country.

But the solution is a shift in compensation, not revolution or regulation. Let all employees be paid in a combination of cash and stock as top managers are now. That way the employee’s risk of job loss in a changing economy will be denominated in stock. And he or she can walk away with the equity if laid off. If the stock then goes up, so much the better.

It’s an idea that is gaining in U.S. business. Microsoft, one of the world’s most successful corporations, uses stock options as an integral part of compensation. The software company pays less than the going rate to programmers and other employees but makes up the difference in stock options that acquire value as Microsoft’s earnings and stock price go up.

And if earnings and stock price don’t go up, well, employee options are worth less, just like those of Microsoft Chairman Bill Gates. Share reward, share risk.

What we’re seeing is another stage in the long evolution of the corporation dating to the 1930s when scholars noted that professional managers had taken the upper hand from passive shareholder owners.

That balance shifted again in the 1970s as the growth of pension funds, which now control two-thirds of most large corporations, concentrated shareholder power.

The 1970s also saw massive inflation, which wiped out returns to pension fund shareholders. And that gave rise to corporate mergers and buyouts in the 1980s as pension funds made up for lost returns.

One feature of that period was to tie managerial compensation directly to stock prices. The result, a decade and a bull market later, notes shareholder activist Nell Minow, is today’s exaggerated executive pay.

But it’s a passing irritant. Spreading the wealth to all employees and new ways of calculating compensation will lessen discontent. Chrysler recently said it would base stock options on increases in product quality.

That of course begs the question of whether front-office executives or assembly-line workers are more responsible for car quality. The answer clearly is that both are, and if options are to be granted, both classes should have them.

What U.S. business should be headed toward is a recognition of the old truth that wealth production is the important purpose of the corporate enterprise and that depends on integrating goals of all its constituencies--shareholders, employees, suppliers, customers.

On the other hand, if business ignores mounting public criticism, we could reap a whirlwind. When presidential candidate Patrick Buchanan called chief executives “bloodless corporate butchers,” nobody shouted him down.