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Stock options lose favor, but still fuel big pay totals:

May 9, 2005

The numbers boggle the mind and dominate the pay totals.

Last year, Eli Lilly and Co. boss Sidney Taurel received stock options that could balloon in value to $18 million over the next decade, even if the company's shares underperform the stock market's historical average return.

The grant of options to buy 400,000 shares of stock accounted for nearly 80 percent of the $23 million in compensation doled out last year to Lilly's chairman, CEO and president.

Options made up 85 percent of the $16.5 million in pay received by J. Raymond Elliott, Warsaw-based Zimmer Holdings Inc.'s chairman, CEO and president. In addition, during the year he cashed in a stash of older options, reaping a $14 million profit.

Confronted by skeptical shareholders and a looming change in accounting rules, U.S. companies in recent years have scaled back the lavish stock option grants in vogue during the 1990s.

But they're far from swearing them off. As many Indiana companies showed last year, options remain the life of the executive compensation party.

IBJ's analysis of Securities and Exchange Commission filings for all Indiana public companies turned up 41 executives receiving option grants valued at $1 million or more in their companies' fiscal years ending in 2004.

Options generally give recipients the right to buy stock in the future at the price on the date of grant. To value option grants, IBJ assumed a company's stock price would increase 5 percent a year for the life of the option, typically 10 years. Such performance would be well below the 10-percent average annual return for the Standard & Poor's 500 stock index over the past 50 years.

There are no guarantees, of course. Option grants have no value if a stock price falls below the exercise price. So far, that's the case with the options Taurel received in 2004.

The board granted them when shares traded at $73.11, or 22 percent higher than the stock price May 5.

"We have a number of years of stock options that are underwater," said Sharon Sullivan, Lilly's vice president of global compensation and human resource services.

Because executives profit only if the stock price rises, options serve as a motivational carrot. But executive pay watchdogs say relying on options also has drawbacks, including fostering a mentality among executives to think short term in order to boost options gains.

Critics note that large option grants also can swell the number of shares outstanding, diluting earnings per share. And then there's the question of who's really responsible for an increase in stock price. Executives receiving large grants can profit handsomely in a frothy market, even if they had little to do with the gain.

"Standard stock options can give windfalls to executives who are lucky enough to hold them during a bull market and penalize executives who hold them during a bear market," according to a union-backed proposal to reform Lilly's pay practices that the company's shareholders voted down last month.

Many companies are reducing their reliance on options and instead doling out more restricted stock. Proponents say restricted stock, which vests over a period of years, encourages executives to make wise long-term decisions, rather than focus on short-term movements in the stock price.

Helping drive the shift is a new Financial Accounting Standards Board rule that will force most companies to start counting options as an expense on their balance sheet next January, the same way they already do other forms of executive pay.

Before this rule appeared on the horizon, boards tended to treat options like "free money" when they paid their CEOs, AFLCIO analyst Brandon Rees said.

"When you don't measure the cost of something, it tends to be abused, and that's what happened with stock options in the 1990s," he said.

The AFL-CIO, which represents more than 13 million U.S. workers, monitors executive pay through annual research and its Executive Paywatch Web site.

Options represented about two-thirds of a typical executive compensation package a few years ago, Rees said. Now, they make up about one-third, he said, partly because of the expensing requirement.

Early this year, Lilly told investors it will scale back option grants in favor of restricted stock grants tied to hitting specific earnings goals. The expensing requirement provided the company a strong nudge. Expensing options last year would have reduced earnings $260 million, or 14 percent.

Few companies are talking about eliminating options altogether, though. Guidant Corp., for instance, grants options to all its employees, a move company officials believe has played a big role in its success.

Employees "can directly see the translation of their work into value creation," said Doug Wilson, the company's vice president for global human resources services.

That's especially true for executives occupying the top rungs on Guidant's corporate ladder. Guidant President and CEO Ronald Dollens has a stockpile of unexercised stock options worth $86.5 million, tops among all Indiana public company executives.

Wilson said that wealth reflects the strong performance of Guidant stock. The company went public more than a decade ago at $4.50 a share. In December, New Jerseybased Johnson & Johnson agreed to buy it for $76 a share, or a total of $25 billion-a deal that's expected to close later this year.

Guidant representatives dominate IBJ's ranking of executives with the most valuable option stockpiles, holding five of the top 10 positions.

"This is exactly what you would expect if you see the type of growth we've had in terms of creating shareholder value," Wilson said.

Super-sized option grants also help. Guidant's board has awarded Dollens slightly more than a million options to buy the company's shares since 2000, SEC filings show.
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