Re: Questionable Compensation

RenaissanceRe Holdings (NYSE:RNR) is asking shareholders to approve a 6-million-share stock option plan, equal to about 8.5% of the current outstanding shares. Shareholders might be quite unsettled that the board of directors thinks the wisest thing to do is give away a twelfth of the company to management. But RenaissanceRe has performed well in the past, and the option plan is unusual, so it deserves a closer look.

The unconventional aspects of the option plan include pricing the options at 150% of the market value of the shares at the time the options are granted, no repricing of options, and a four-year vesting period. In addition, RenaissanceRe CEO James Stanard will not draw a salary for three years but just receive 2.5 million options.

Traditionally, when corporate executives feed at the trough, they take home both a huge paycheck and yearly vesting options priced at the market value. So RenaissanceRe's plan looks more reasonable than some. Plus, Stanard's receiving only options as compensation is a strong statement about his outlook for the stock.

But when you look at it with a more cynical eye, the deal doesn't look great for shareholders. Using RenaissanceRe's historical volatility of 30% over the past five years and a risk-free interest rate of 4.25% as inputs to the Black-Scholes model, Stanard's options have a present value of $37 million, or about $12 million a year. That's a decent jump over his 2003 compensation of $5.6 million.

At first glance, the 150% exercise price seems quite positive, but it really only reduces the value of the options by about 25%.

Another major problem with this kind of compensation package is that it works only if the stock goes up. Suppose instead, RenaissanceRe's stock has a five-year period similar to Microsoft (NASDAQ:MSFT), Dell (NASDAQ:DELL), or Coca-Cola (NYSE:KO) since 1999. Perhaps the stock wanders around like a drunken cow but remains well below the strike price the entire time.

In that scenario, will the CEO work for nothing, quietly regretting his mistake in not taking cash compensation? I suspect not. Instead, I think he'll go back the compensation committee, make a wry joke about the unfortunate turn of events, and renegotiate his pay package. So, executives either make boatloads of money if the stock performs or renegotiate to make the normal large quantities if it does not.

Before this, I thought that RenaissanceRe could be a candidate for the new Motley Fool Inside Value newsletter. But now, it might be more appropriate to consider it another case study in why Fools hate stock options.

Want to check out the new value-focused newsletter, Inside Value? Sign up for a free, no-obligation trial today.

Fool contributor Richard Gibbons owns shares of RenaissanceRe, but none of the other securities mentioned in this report.