Friday, October 19, 2007

Upside Down

I love the concept of time travel. Let’s head back to 1981, when Ronald Reagan pushed through those huge tax cuts that were the beating heart of Reaganomics (and now are the beating heart of Romneyomics, Giulianiomics, Huckabeeomics and so forth).

Reagan revived the concept of tax-favored incentive stock options that year. The darn things had been used in the fifties and sixties, but got tossed out of the tax code in the late seventies because - you’ll be shocked - some had abused them. But compensation experts assured Congress that sprinkling CEOs with stock option fairy dust would motivate them to make bigger profits for shareholders.

We’ve been told this for the last twenty-five years, and companies still earnestly repeat it in their CD&As. That doesn’t mean it’s right. In a 950-company study published last week, economists Gerard Sanders and Donald Hambrick concluded that what stock options do is tempt CEOs to take extreme risks. And in the case of CEOs getting more than half their pay in options, these bets led to big losses significantly more often than they led to big gains.

Why would this happen? Sanders and Hambrick suspect that “option-loaded CEOs are riveted on upside possibilities, with little concern for downside,” and take chances they wouldn’t take if they owned the stock outright. This follows from the structure of stock options, which are basically win-no lose.

You can poke some minor holes in their argument, as Graef Crystal did in this Bloomberg piece. Still, the fact remains that when companies ask shareholders to approve option plans, they wax poetic about the upside incentives, and that’s where the analysis ends.

This week brought other news about managerial behavior. A study mentioned in Time Magazine tied CEO decisionmaking to a non-monetary factor: birth order. The study’s author, an industrial psychologist, says firstborn chief executives are better at "incremental improvements," while those who come later in the birth order are more adept at "transformational change.”

So listen up, compensation designers. Human behavior is complex. If you keep pretending you understand it, we’ll zap you back to the 1980s, where there are no cellphones or iPods, and you can forget about beeping open your car door.

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