CEO Compensation in Options 1965-2011

The following chart shows the relationship between CEO-worker compensation in the form of options (H/T Greg Mankiw). Usually executives and sometimes employees are granted stock options so the company can tie performance to how well the company is doing. The idea is that if that people are given stock options they will want to work hard to increase the value of the company thereby increasing their own compensation.

Options are granted by the company to the employee. However, the employee must wait a period of time before they can actually exercise or have the right to buy the options. I have a feeling many people think executives can just cash out there options whenever they want however the board of directors and shareholders are not stupid. The employee has to wait until the vesting period is over. The vesting period is the amount of time the employee has to wait before he or she sells their options. Typically the average amount of time is between 4-5 years. So really management or employees can’t have a short term view since they can’t even cash out their options until the 4 or 5 year period is over.

The blue line in the graph shows the ratio between the options that were granted and when the options were actually exercised by the employee. What is interesting is nearly every year from 1998 to around 2003 the options or the money that employees got was actually worth less than when they were granted. One reason for this is because the stock could actually decrease in value which decreases the value of the shares. Also the relative pay of CEOs increased dramatically in the 90’s and then fell by half. I have a feeling though people will point out the factor of how much CEOs make compared to workers. There are a couple of points I would bring up. The first is that employees often times don’t in the same position forever. Especially early on in their career they are trying to move up and get a higher paying job. By moving up this would decrease the factor of what CEO’s make compared to employees. Some people who start at the bottom of the company reach an executive level position before their career is over. Other people may get promotions however not want to take them due to family responsibilities, illness, or may not want the increased responsibility and pressure. Executives have extremely stressful jobs. They essentially spend their whole life at the company (or many different companies). Another point that is important to point out is that executives often pay ordinary income on their options which in places like New York City (city, state, and federal taxes) can easily exceed 50%.

I honestly believe only a few people really want to be executives. Everyone claims they want to get to the top but when you look at who wants to and actually can make it to the top it is only a very small percentage of people. Maybe next time when people complain about CEO compensation they should first understand what it is like to be a CEO.