Sellers or keepers? Stock retentions in stock option plans

Introduction

This article addresses two questions: doemployee stock option holders divest orretain their stock on exercise, and what arethe main influences upon their decision?The answers are based on data derivedfrom a set of employee-level surveys ofmajor publicly held companies with all-employee stock option programs in theUnited Kingdom. We find that over 40% ofoption holders retain their shares for a yearor longer after exercise, and the mostimportant individual-level influences onthe decision whether to divest or retain arethe structure of investment portfolios, thereasons for participating in the stock optionplan, and age.

To the best of our knowledge, thisresearch is one of the first attempts in thehuman resource management literature toaddress these issues, though there is a smallbody of work on this topic in the executivecompensation literature in finance (see Hud-dart & Lang, 1996; Ofek & Yermack, 2000).That literature indicates employees tend toexercise well before full term, thereby sacri-ficing some of the Black-Scholes value of theoptions, and that exercised shares usually aredivested more or less immediately. Stockoptions do not appear to be a well-troddenroute to substantial employee share owner-ship, even in the short and medium term, formost option holders in the United States (fora discussion of these issues, see Blasi, Kruse,& Bernstein, 2003).

SELLERS OR KEEPERS? STOCK RETENTIONSIN STOCK OPTION PLANS

Human Resource Management, Fall 2005, Vol. 44, No. 3, Pp. 319–336© 2005 Wiley Periodicals, Inc. Published online in Wiley InterScience (www.interscience.wiley.com).DOI: 10.1002/hrm.20073

Andrew Pendleton

This article examines stock-holding behaviors among participants in Save As You Earn (SAYE)stock option plans in the United Kingdom. It examines the influences upon the decision to sellor retain stock once options have been exercised, utilizing data from a study of option plan par-ticipants in five large U.K. companies. The main findings are that investment portfolios, the rea-sons for participating in the option plan, and age are important influences on the decision toretain stock. Contrary to expectations, income and risk preferences have little direct influenceonce other factors are considered. These results have implications for research, corporate prac-tice, and national policy. © 2005 Wiley Periodicals, Inc.

Correspondence to: Andrew Pendleton, Professor of Human Resource Management, University of York, York,YO10 5DD UK, 44 1904 434169, [email protected]

320 • HUMAN RESOURCE MANAGEMENT, Fall 2005

The early exercise and sale of optionsobserved in previous literature suggests thatemployees value options rather differentlythan Black-Scholes and related formal valua-tion models. Finance scholars typicallyattribute this discrepancy to “psychologicalfactors” (Core & Guay, 2001; Heath, Hud-dart, & Lang, 1999) and to risk aversion(Huddart, 1999). For the most part, though,these explanatory factors are not usuallyassessed directly, primarily because of thedata sources used by finance scholars. Thenovelty of the current article is that itdirectly addresses employee-level factors thatinfluence keep/sell decisions.

We propose two sets of explanations foremployee behavior in stock option plans. Thefirst is rooted in the finance literature andattempts to amplify arguments and insightsrelating to risk aversion and portfolio diversi-fication. We predict that employees with aportfolio of other investments will be morelikely to retain their shares but that thoseparticipating in other option grants by theiremployer will more likely sell shares at exer-cise. The second prediction, derived from theemployee share ownership literature (seeKruse & Blasi, 1997), suggests that prioremployee orientation to equity-based instru-ments has a strong influence on employee-level outcomes. Drawing on a common dis-tinction in the literature between extrinsicand instrumental orientations (Buchko,1992; French, 1987; Klein, 1987; Pierce,Rubenfeld, & Morgan, 1991), we predictthat a desire for financial returns will have adifferent impact on the sell/keep decisionthan that of a desire for involvement. We alsoexamine the influence of demographic char-acteristics on stock retention.

The results are clearly consistent withthese predictions. Employees with diversi-fied portfolios of equity holdings are morelikely to retain their options-derived shareswhile those with further option grants rebal-ance their portfolios by selling their shares.Employee orientations to share options havea significant bearing on share-retentiondecisions. Extrinsic orientations to shareplans are associated with share sales, whileinvolvement-type orientations clearly pre-dict share retentions. Retentions also

become more likely with age. Overall, thefindings suggest that the behavior ofemployee option holders is more rationalthan tends to be portrayed in the recent lit-erature on this issue in finance. Employeebehavior is consistent with sound portfolioprinciples, and with what they want toreceive from stock option plans.

These findings have a number of policyimplications. If stock option plans are con-ceived of as a route to ownership (as tends tobe the case in the United Kingdom), then itis clearly pertinent to assess whether theyactually succeed in this. The results implythat the success of option plans in generatingemployee stock ownership will depend, atleast in part, on the diffusion of an employeeculture that values involvement in the com-pany, and a broader share ownership andinvestment culture that promotes diversifiedwealth portfolios. Equally, our findings indi-cate that, contrary to the views of some crit-ics of employee stock plans, the provision oftax breaks to promote stock ownership doesnot necessarily lead employees to make ill-judged decisions to concentrate their wealth.

These policy questions in the UnitedKingdom provided the context and therationale for the research, with the centralissue being the extent to which option plansbring about share ownership. At the turn ofthe century, there was some debate as towhether tax breaks should be provided foroption plans that did not lead to stock own-ership. This research project was designed tocontribute to this policy discussion andapparently was an important influence onthe political decision to retain existing taxbreaks. Employee surveys were conducted in11 companies, with data from five of thesebeing utilized here. By collecting demo-graphic and attitudinal information directlyfrom employees rather than relying on com-pany filings to regulatory authorities, we areable to develop a fuller picture of the influ-ences on employee share retention behaviorthan has been available so far.

Background

Stock option plans are now widespread inthe United States and United Kingdom,

Employees withdiversified port-folios of equityholdings aremore likely toretain theiroptions-derivedshares whilethose with fur-ther optiongrants rebal-ance their port-folios by sellingtheir shares.Employee ori-entations toshare optionshave a signifi-cant bearing onshare-retentiondecisions.

Sellers or Keepers? Stock Retentions in Stock Option Plans • 321

While we knowa reasonableamount aboutthe incidence,coverage, andeffects of broad-based shareoption plans(Sesil,Kroumova,Blasi, & Kruse,2002; Weedenet al., 2001),we know verylittle aboutwhatparticipatingemployees dowith the sharesthat areavailable tothem in theseoption plans.

especially for executives. Hall and Murphy(2002) found that nearly every firm (94%) inthe Standard and Poor 500 granted optionsto top executives by the end of the twentiethcentury. In recent years, the base of optionplans has been widening: Weeden, Rosen,Carberry, and Rodrick (2001) suggest thatjust under 20% of U.S. public companiesoffer options to a majority of their workforce(p. 469). More recently, findings from theU.S. General Social Survey in 2002 indicatethat around 13% of the private-sector work-force (14 million employees) holds options(Freeman, Kruse, & Blasi, 2004). In theUnited Kingdom, option plans are also wide-spread, with three main tax-approved optionplans now in operation. Eighty-five of the100 largest listed firms (the FTSE 100) hada broad-based Save As You Earn (SAYE)option plan (the subject of this article) in2003 (Inland Revenue, 2004). Governmentstatistics indicate that about one millionemployees (3%–4% of the employed laborforce) enter a SAYE plan each year (InlandRevenue, 2004).1

While we know a reasonable amountabout the incidence, coverage, and effects ofbroad-based share option plans (Sesil,Kroumova, Blasi, & Kruse, 2002; Weeden etal., 2001), we know very little about whatparticipating employees do with the sharesthat are available to them in these optionplans. What do employees do with theunderlying stock on exercise: do they sell itimmediately or retain the shares, therebybecoming employee stockholders? Why dothey do what they do?

The finance literature provides us withanswers to the first of these questions but isless convincing regarding the second. Fifty-five percent of Anderson’s (1999) sample ofexecutives sold 50% or more of their sharesimmediately on exercise. Weeden et al.(2001) found that 40% or more employeessold their shares at exercise in 70% of firms,and nearly all sold their shares in 30% ofcases. Heath et al. (1999) showed that “cash-less exercise” (i.e., simultaneous exercise andsale of shares) constitutes more than 90% ofall exercise activity (1999), while Ofek andYermack (2000) found that executives divestmore or less all of their options on exercise.

Option exercises are therefore seen as astock-sell decision in the literature (Carpen-ter & Remmers, 2001).

The main focus in the literature, in fact,is the timing of stock option exercises(Anderson, 1999; Carpenter & Remmers,2001; Core & Guay, 2001; Heath et al.,1999; Hemmer, Matsunaga, & Shevlin,1996; Huddart, 1999; Huddart & Lang,1996, 2003; Kasznik, 2003), which, with theexception of the series of studies by Huddartand Lang, focuses on top executives. The keyfinding from this literature is that optionholders exercise early, typically shortly aftervesting. Huddart (1999) found that nearlytwo-thirds of employees exercise theiroptions within six months of the vesting date.Early vesting is more pronounced amonglower-level employees than executives, butthe latter also seldom retain their optionsuntil maturity (Huddart & Lang, 1996).

Risk aversion is viewed as the key influ-ence on the timing of exercises. The startingpoint is that a risk-neutral employee will holdan option to expiration because the expectedpayoff at maturity will always exceed theexpected payoff from early exercise (in stan-dard valuation models). However, there is achance that exercise at maturity will result ina zero payoff, but no chance that early exer-cise will have this outcome (why exercisewhen an option is “out of the money”?) (seeHuddart, 1999, p. 120). Thus, risk-averseemployees will likely exercise early, and thefinding that many employees do indeed exer-cise early is seen as prima facie evidence ofthe influence of risk aversion on behavior.

Similar arguments help to explain whyearly exercises also mean stock sales. It isclearly risky to exercise options early withoutselling the underlying stock because of expo-sure to future stock volatility.2 It makes littlesense for risk-averse employees seeking fur-ther capital gains to exercise and hold whena less risky strategy would be to retain theoptions. A further influence is likely to beliquidity constraints. The up-front cost ofexercising the option will likely be met byshare sales by liquidity-constrained employ-ees, unless there are loans or savingsarrangements in place.3 This factor is likelyto be of particular importance if a tax liabil-


ity arises on exercise, as is usually the casewith “unapproved” or “unqualified” arrange-ments. In the United States, 49% of firmswith option plans offer such nonqualifiedoptions to nonmanagement employees(Weeden et al., 2001).4 Thus, financing andtax arrangements may be a further influenceon sale behavior.

Turning to other influences on sharesales, Ofek and Yermack (2000) find thatexecutives typically sell shares acquiredthrough restricted stock programs followingnew option grants. They suggest that risk-averse executives actively rebalance theirinvestment portfolios to diversify away unsys-tematic risk so that an optimal level ofequity-based holdings is maintained (cf.Core & Guay, 2001). However, this literaturedoes not account for other forms of wealththat might have a bearing on decisions aboutoption exercise and share sale. If optionholders have a diversified portfolio of invest-ments, of which options in their employer’sstock are just one part, a given level of riskaversion should not lead to the same pres-sure to exercise and sell the employer’s stock.Further, as Meulbroek (2001) has argued,the options will be worth more to theemployee where portfolios are diversified. Itis thus worth examining the impact of otherinvestments on the stock sell/retention deci-sion, and it can be predicted that stock reten-tions are more likely where employees havediversified wealth portfolios. For the samereason, it can be further predicted (Ofek &Yermack, 2000) that further option grants ofthe employer’s stock will be associated withshare sales as employees attempt to rebal-ance their portfolios.

The evidence that many employees exer-cise and sell early conflicts with the predic-tions of formal evaluation models such asBlack-Scholes. Employees appear to valueoptions differently from what is predicted bythese models. This phenomenon has givenrise to the view that “psychological” factorsinfluence employee decisions (Core & Guay,2001; Heath et al., 1999) and that formalvaluation models neither adequately capturethe unique features of employee stockoptions nor fully incorporate the psychologi-cal dimension. A core assumption in Black-

Scholes is risk neutrality. Yet the concentra-tion of human capital and employer optionsviolates this principle. As Meulbroek puts it,“the exposure to firm-specific risk that isessential for generating the right . . . incen-tives also imposes a cost on (employees) bycompelling them to hold less-than-fullydiversified investment portfolios” (2001, p.5). Thus, the value attached to options bytheir recipients may be lower than the cost tothe firm of providing options. In a similarvein, Lambert, Larcker, and Verracchia(1991) and Hall and Murphy (2002) haveshown the value of options to employees canbe much lower when risk aversion replacesrisk neutrality. Other criticisms of the suit-ability of Black-Scholes include the nontrad-ability and the potential for forfeiture ofemployer stock options. It has also beenargued that, contrary to Black-Scholes,volatility can depress value (Lambert et al.,1991). This view is supported by evidenceindicating that the extent of variance in stockreturns is positively related to early exerciseof stock options (Hemmer et al., 1996).

The view in the finance literature that“psychological” factors significantly influ-ence exercise behavior suggests that greaterattention needs to be paid to the orientationof employees to stock-based rewards. As thereward literature suggests, employee expec-tations and orientations toward paymentsystems are likely to have a significant bear-ing on their behavioral responses to thesesystems (Brandes et al., 2003). Theemployee share ownership literature pro-vides useful insights here. Three perspec-tives have been identified: the intrinsicmodel, whereby employees value stock own-ership as an end in itself; the instrumentalmodel, whereby stock ownership is valued tothe extent that it facilitates involvement andparticipation in the company; and theextrinsic model, whereby stock ownership isvalued according to its capacity to deliverfinancial returns (Buchko, 1992; Klein,1987; Pierce et al., 1991). The evidenceprovides support for the extrinsic and instru-mental models (see French & Rosenstein,1984; Klein, 1987; Klein & Hall, 1988),though some studies indicate that extrinsic-type effects may operate indirectly (Buchko,

The evidencethat manyemployeesexercise andsell earlyconflicts withthe predictionsof formalevaluationmodels such asBlack-Scholes.Employeesappear to valueoptionsdifferently fromwhat ispredicted bythese models.


Drawing on thefindings of thisliterature, wepredict thatstock sell/keepdecisions willbe influencedby priororientations tostock options.Those with aprimarilyfinancialorientation tostock optionsare predicted tosell rather thanretain stock,while thoseentering stockplans forinvolvement-type reasonswill be morelikely to retainit.

1992). Although, these models were initiallyproposed to explain the impact of employeeownership on commitment, they clearly alsorelate orientation to ownership—greatercontrol is unlikely to lead to greater com-mitment if control is not important toemployees. French (1987), in particular, hasemphasized the role of financial orientationsto stock ownership, and has argued thatemployee decisions about stock retentionwill be influenced by what is wanted fromstock ownership.

Drawing on the findings of this litera-ture, we predict that stock sell/keep deci-sions will be influenced by prior orientationsto stock options. Those with a primarilyfinancial orientation to stock options arepredicted to sell rather than retain stock,while those entering stock plans for involve-ment-type reasons will be more likely toretain it. The financial or extrinsic explana-tion is consistent with the spirit of thefinance literature, as the latter assumesrational, self-interested agents. The poten-tial for involvement-type factors to influencestock-retention decisions is, however, morenovel in the specific context of stock optionplans. It implies that the value of stockoptions to their recipients is influenced byfactors other than those captured by finan-cial valuation models.

Although the finance literature hasrecently emphasized the importance of psy-chological factors in option exercises/stocksales, it is typically unable to observe thesedirectly. The typical data sources are trans-action reports on option awards and exer-cises that are required to be submitted tothe Securities and Exchange Commission(SEC), and that are held on Standard andPoor’s Execucomp. These data identifyawards and exercises of top executives butnot of the remainder of the workforce.Employee transactions are reported inaggregate form (as in Core & Guay, 2001)so it is not possible to analyze employeebehavior in a precise or direct way. Further-more, reliance on these sources precludesaccess to information on employee charac-teristics (attitudes, demographics, etc.).This shortcoming extends to portfolio com-position. Despite the centrality of risk aver-

sion and diversification in the finance liter-ature, only Ofek and Yermack (2000) haveinformation on portfolio composition. Hud-dart and Lang (1996, 2003) differ some-what in using data on option awards andexercises for all employees obtained directlyfrom the eight firms in their study, but heretoo there is no direct data on employeecharacteristics. The reliance on this type ofinformation requires that some heroicassumptions have to be made about thevalidity of some of the proxies for employeeorientations, characteristics, and behavior.For instance, occupational level doubles asa proxy for liquidity constraints and riskaversion, but even occupational level is notmeasured directly. In Huddart and Lang(1996), the volume of options proxies foroccupation on the grounds that optionawards will be linked to occupational level.The premise in our article, therefore, is thatwe need to observe employees directly if wewant to fully understand the determinantsof option/stock behavior.

To summarize, we predict that there willbe additional influences on stock-retentiondecisions along with those already identifiedin the finance literature. This literature hasshown that liquidity constraints, risk aver-sion, and portfolio rebalancing all affectexercises and simultaneous stock sales. Devi-ations from “rational” valuations of optionsare attributed to “psychological” factors, butthe nature of these processes are necessarilyunclear given the typical data sources usedby scholars of finance. We predict, in accor-dance with finance theory, that the extent ofportfolio diversification will also influencethe sell/retain decision. Further, drawing onlong-standing literature on employee owner-ship, we predict that orientations to equityplans will be an important influence. Finally,we expect that other employee characteris-tics will affect sell/retention decisions.

The Save As You Earn Stock Options Plan

In the remainder of the article, we investi-gate the determinants of stock retentionbehavior in the U.K. Save As You Earn (orSharesave) approved stock option plan. Thisquestion assumed political relevance in the


United Kingdom toward the end of the twen-tieth century. It was widely feared in the cor-porate and share plan community that thegovernment intended to abolish SAYE on thegrounds that it failed to bring about long-term share ownership. It was believed thatthe vast majority of SAYE participantsdivested their shares at or very shortly afterexercise. The Blair government, like its pred-ecessors, wanted to promote long-termemployee share ownership so as to alignemployee interests with those of the firm,thereby supporting employee behaviorsthought to be conducive to good businessperformance. If all-employee option planswere failing to achieve the public good oflong-term employee share ownership, then itwas questionable whether tax concessionsshould continue to be available to its partici-pants. The study reported here was designedto contribute to this political debate.

Save As You Earn was introduced byMargaret Thatcher’s government in 1980. Itenables companies to award share options totheir employees for exercise in either three,five, or seven years at a strike price with upto a 20% discount on the prevailing marketprice at award.5 Unlike typical U.S. stockoptions plans (and other U.K. govern-ment–approved option plans), there is littleemployee discretion in the timing of exer-cises, though there is freedom not to exer-cise. At the same time that options areawarded, employees begin participation in aSave As You Earn savings plan at a level thatwill enable them to exercise the option at thechosen point in the future. To qualify as anapproved plan, a scheme must be open to allemployees with five years of service, andmust be available on similar terms. The pres-ence of the savings plan arrangements willclearly lead to different decision parametersat exercise from those plans where savingsarrangements are absent: employees do nothave to sell exercised shares to meet the exer-cise price.

This option plan, when approved by theInland Revenue, offers a variety of benefitsto the employee. The 20% discount is free ofincome tax at the point of grant, while thesavings contract attracts an income tax-freebonus at termination. There is no income

tax liability on any “paper” gain at exercise.Instead a capital-gains tax (CGT) liabilityarises on the sale price minus the strikeprice when shares are eventually sold. Incontrast, therefore, to unapproved orunqualified option arrangements, there is notax liability at exercise. Furthermore, thereis a substantial capital-gains tax annualallowance in the United Kingdom, and thismeans that many employee shareholderswill be able to sell their shares tax-free.Unlike the United States, there is norequirement that shares be held for a yearafter exercise. Since this study was con-ducted, the capital-gains tax position hasbecome more favorable still in that any CGTliability on share sales tapers to zero accord-ing to the length of time that shares are heldbetween exercise and sale.

SAYE has been a very popular shareoption plan, especially among listed firms.Since it was created in 1980, over 2,400plans have been approved by the Inland Rev-enue, and currently around 700 are in oper-ation. The number of employees receivingoption grants has been around one millionper year for each of the last five years, withthe total initial value of option grants beingin the region of £3,000 million ($4.5 billion)each year (Inland Revenue, 2004). The aver-age initial value per employee of recentoption grants has been in the region of£3,000 ($4,500).

Data and Approach

The data were obtained from a program ofemployee surveys in 1999 organized by theshare-lobbying organization Proshare andfinanced by Halifax (now part of HBOSPLC) and Abbey National PLCs. Elevenlarge U.K. companies with either (or both)SAYE and Approved Profit Sharing schemeswere selected to participate. Questionnaireswere distributed to 24,976 employees inthese 11 companies, and 6,105 responseswere received (24% response rate). Eight ofthe companies had a SAYE plan, and 4,795respondents were either current or past par-ticipants in a SAYE plan.

A number of steps were taken to con-struct a subsample suitable for the analysis

Save As YouEarn wasintroduced byMargaretThatcher’sgovernment in1980. Itenablescompanies toaward shareoptions to theiremployees forexercise ineither three,five, or sevenyears at a strikeprice with up toa 20% discounton theprevailingmarket price ataward.


undertaken here. First, the analysis was lim-ited to the eight companies with SAYE. Wethen omitted three companies who had lessthan 100 respondents. The sample was thenreduced to those individuals with a maturingSAYE contract (N = 2,058). The sample forthe multivariate analysis was reduced furtherwith reference to a question on respondentactions at exercise. For ease of coding, thosewho decided not to exercise the options andthose who both took cash and exercisedsome options were excluded, as were thosewho exercised their options but more or lessimmediately sold some of their shares. Thisreduction left a final sample size of 1,631.Those groups excluded from the analysis arenot without interest, but they were excludedeither because their decision is not directlyrelevant to the analysis here, or, as in thecase of those who both sell and hold, theirbehavior cannot easily be coded in a satisfac-tory way.

As well as stock-retention behavior, thesurvey instrument contained information oncurrent SAYE participation, risk preference,salary, age, orientations to share plans, andother investments. The design of the ques-tionnaire posed some challenges, as collect-ing reliable data on shareholding levels anddivestment activity is known to be problem-atic. Employees rarely have this informationreadily at hand, and there is the danger thatseeking comprehensive and precise financialinformation will drive down response rates tounacceptably low levels. For this reason, theliterature on executive options almost alwaysuses publicly disclosed data from SEC fil-

ings. The decision taken in our study was tocompromise on the precision of financialdata and to concentrate instead on patternsof behavior. Thus, we ask whether employeeshave divested shares but we do not ask forthe value of share sales or the precise timingof any sale activity.

Before presenting results, we providebrief details on the expected determinants ofthe sell/retain decision and the constructionof our measures. The first three items relateto measures that have previously been incor-porated in the finance literature on optionexercises, though not necessarily in the sameform. Subsequent items relate to the addi-tional arguments advanced earlier. Descrip-tive statistics and correlations between thevariables are shown in the correlation matrixin Appendix A.

Liquidity Constraints

All things being equal, those with lowerincomes probably will face greater pres-sures for liquidity after options have beenexercised, even though they are likely tohave subscribed to lower levels of options(the correlation between current SAYE sav-ings and income is 0.463, significant at0.000).6 We have an ordinal measure ofincome in the survey, with each value rep-resenting a £5,000 (approximately $7,500)salary band.

A further finding in the literature is thatliquidity constraints may be a factor inoption exercise—those who need the cashwill exercise options closer to vesting than

Background Information on Companies and Respondents

U.K. Number Who Proportion of Workforce Number of Response Have Exercised Respondents Who Have

Company 1999 Respondents Rate (%) Options Exercised Options (%)

Company 1 38,656 471 19 317 67Company 2 17,555 1,316 33 806 61Company 3 4,000 823 16 268 33Company 4 27,963 1,344 38 568 42Company 5 20,049 453 36 287 63Totals 4,407 25 2,246 51

TABLE I


others. Huddart and Lang’s (1996) resultsare consistent with this finding, though it isnot possible to separate liquidity constraintsfrom risk aversion in their study. Liquidityconstraints appear likely to influence divest-ment behavior when options have been con-verted into stock: those facing higher liquid-ity constraints are more likely to divest stockfor cash. We therefore predict that those onlower incomes will be more likely to sellshares around the time of option exercise.

Portfolio Rebalancing: Employer’s Stock

Modern portfolio theory predicts thatemployees should minimize unsystematicrisk by portfolio rebalancing. If employeeshave an optimal level of share ownership intheir employer (and if it is assumed that thelevel of participation in a share plan at anyone time reflects this), then employees willdivest shares when they receive furtherbatches of shares or options (Ofek & Yer-mack, 2000). Weeden et al. (2001) foundthat 57% of U.S. stock option firms makeannual grants of options to nonmanagementemployees. U.S. practice of annual optiongrants is quickly catching on in U.K. execu-tive compensation but is less common in all-employee plans. Even so, most large listedfirms typically have more than one SAYEplan in operation at any given time, and all ofthe firms in the study had four or more plansin operation at the time of the research.Based on the findings of Ofek and Yermack(2000) and Blasi et al. (2003), we predictthat divestment behavior will be associatedwith higher participation in subsequentplans. We therefore ask respondents howmany Sharesave contracts (SAYE CON-TRACTS) they currently are participating in.

Risk Preferences

Portfolio planning is a function of risk pref-erences. Although risk aversion is central toanalyses of share exercise behavior, to thebest of our knowledge no study of employeeoptions so far has collected informationdirectly on employees’ risk preferences (c.f.Meulbroek, 2001). The executive compensa-tion literature typically models varying levels

of risk preference or else uses proxy meas-ures. To assess risk preferences we use anattitudinal approach, with respondents askedto evaluate the statement “Share ownershipis only worthwhile if there is no riskinvolved” on a five-point scale where 1 =strongly agree and 5 = strongly disagree. Thisvariable is referred to as RISK PREFER-ENCE. The prediction is that employeeswith higher levels of risk aversion will morelikely divest their shares.

Demographic

Studies of savings behavior, including partic-ipation in 401(k) plans (see Clark &Schieber, 1998), indicate that participationin pension savings plans is a positive butnonlinear function of age. In a separate,unpublished analysis, we find a similar pat-tern of savings behavior in Sharesave plans.However, we predict that the likelihood ofholding rather than divesting exercised stockwill rise with age because preferences forcash alternatives to stock will decline for anumber of reasons once early-/mid-careerexpenditure on family has taken place.Shares may well be divested on retirement,but this will not be captured by our employeesurvey. We use an ordinal, five-categorymeasure of AGE, ranging from young to old.We also include a measure of SEX.

Orientation to SAYE

We have argued that employee behavior atthe end of the SAYE contract will be relatedto the reasons for participation in the firstplace. Those who participate to “make a fastbuck” may be inclined to cash in on SAYEprofits at an early opportunity by sellingtheir shares. Conversely, those who join foraffective reasons (i.e., desire for involve-ment) may be more inclined to maintain thesense of involvement after the option hasbeen exercised.

To address this issue, we consider thereasons for SAYE participation. Several ques-tions in the survey enquire into this.Exploratory factor analysis shows two factors(eigenvalues > 1) underlying the data (seeAppendix B). One factor embodies involve-

We thereforepredict thatthose on lowerincomes will bemore likely tosell sharesaround the timeof optionexercise.


On the basis offinance theory,we predict thatthose who ownshares in othercompanies willmore likelyretain theirshares from theSAYE plan, forbalancedportfolioreasons.

ment-type reasons and the other financial-type reasons. On the basis of this result, twoscales were created: INVOLVEMENT (alpha= 0.7577) and FINANCIAL (alpha =0.5498).7 These two scales record entirelydistinct orientations (r = 0.004).

Portfolio Diversification

Finance theory suggests that respondentsretaining employer stock should hold a bal-anced share portfolio of investments outsidetheir employer. Critics of employee equityparticipation allege that employee stockplans supported by tax breaks encourageemployees to violate these portfolio princi-ples. Whether in fact employees do undulyconcentrate their equity investments inemployer plans has not been explored sys-tematically in the literature to date, mainlydue to data availability. To consider theseissues, we use a set of variables indicatingownership of shares other than thosereceived through the SAYE option scheme,including those received from a previousemployer’s share plan (EARLIER SHAREPLAN), de-mutualization of building soci-eties (DE-MUTUAL), privatizations (PRIVA-TIZATION), and share purchases (SHAREPURCHASE). We also ask whether respon-dents invest in personal equity plans (tax-advantaged equity funds similar to U.S.mutual funds), unit trusts, and investmenttrusts (PEP/UNIT TRUST). On the basis offinance theory, we predict that those whoown shares in other companies will morelikely retain their shares from the SAYE plan,for balanced portfolio reasons.

Controls

We control for company-specific influencesby including a set of company dummies(COMPANY 1–4, with COMPANY 5 provid-ing the reference point). Ideally, the effect ofstock price on employee behavior would beinvestigated, but unfortunately this analysisis not feasible for two methodological rea-sons. First, we do not have precise informa-tion on the timing of exercise or sale.Although we have some broad informationon stock price movements and volatility, the

inability to match this closely to exercise orshare disposals casts serious doubt on thevalidity of any findings obtained. The secondis a grouping effects problem. If it is assumedthat exercise in each company takes place atmore or less the same time (as occurs inSAYE plans), the effect of stock price will besimilar for every employee with maturingoptions. Any observed statistical effect couldreflect unobserved characteristics of thefirms in question. Equally, in the absence ofdata on stock price movements, significantcompany dummies may proxy for price move-ments, though we cannot be sure.

Results

Table II provides descriptive statistics onemployee behavior at the maturity of theirSAYE plan. As can be seen, all but 3.4% exer-cised their options at maturity. The key find-ings for our purposes are that 35% divestedthe underlying stock immediately or within ayear, while 44% retained the underlyingstock for a year or longer. A further 17% pur-sued a mixed course of action, whereby theyfreed some cash and retained some shares.The proportion of employees who retainshares for more than a year may seem sur-prising, but it should be remembered thatthese are all tax-qualified plans where the taxliability occurs on the sale of shares, not atthe point of exercise.

In the analysis that follows, we restrictour attention to those who sell all of theirshares within a year of exercise (44% of thefinal sample) and those who retain them allfor at least one year (56%). The first group istermed “sellers” and the second group “keep-ers.” Logistic regression is used to identifythe odds that the various possible determi-nants identified earlier lead SAYE partici-pants to retain their exercised shares. Fourmodels are presented. The first includes onlythese influences that have been empiricallyaddressed in the finance literature to date(though not necessarily in the same form):liquidity constraints, portfolio rebalancing,and risk aversion. The second model addsbasic demographic measures for age and sex.The third model adds measures for orienta-tions to Sharesave, and the fourth adds


measures for portfolio composition. Separatemodels for each set of influences are notincluded, because as the results show, thesemodels supplement, rather than substitute,for each other. Chi-square statistics areshown for each model step as well as themodel summaries (Table III).

“Finance Model”

By itself, the finance model indicates theimportance of liquidity constraints (SALARY),portfolio rebalancing (SAYE CONTRACTS)and risk aversion (RISK PREFERENCE).Those with higher salaries, a smaller numberof SAYE contracts, and lower risk aversion aremore likely to retain their shares after exer-cise. The significance of these variablesdiminishes, however, when other influencesare entered in subsequent steps. The odds ofa given level of risk preference and salaryaffecting the sell/keep decision fall when ori-entations to SAYE and portfolio diversificationmeasures are added. The odds of SAYE con-tracts affecting the sell/keep decision staymore or less the same, but the result has alower level of significance.

These findings are supportive of the viewof Ofek and Yermack (2000), that those indi-viduals currently participating in an optionplan will be more likely to divest stock so asto rebalance their wealth holdings andthereby maintain a desired level of liquidity.Those who retain their shares currently par-ticipate in a smaller number of new SAYEcontracts (median = 3) than do sellers(median = 4). This finding suggests that

employees balance their investment portfo-lios in broadly rational ways.

We do not argue that liquidity con-straints, by contrast, are unimportant. Thepattern of results indicates that the influ-ences identified in the finance literature areimportant, but when a richer range of infor-mation is available, these influences will beembodied in other phenomena.

Demographic

As predicted, the AGE variable is positiveand strongly significant in all specifications:older employees are more likely to retainrather than sell their shares. This result isbroadly supportive of life-cycle interpreta-tions of savings behavior. However, there isno evidence of a hump-shaped distributionwhen age dummies (not shown) are substi-tuted for the continuous measure used here.This finding is perhaps unsurprising, as weare measuring the outcome of a savings deci-sion rather than the entry-level decisionitself. While preretirement employees show alower propensity to save than those justyounger than them, there is no reason tothink that preretirement employers in thepost-55 age group would be more likely todivest shares than those in the age cohortimmediately below them.8 If anything, thereverse (as indicated here) is likely to be thecase, since at this stage of the life cycle,other demands on income (such as raisingchildren) are likely to be falling.

SEX has a weak and insignificant influ-ence on the sell/keep decision.

Decisions on Share Option Exercise/Share Divestment/Retention

Proportions of employees in each decision groupProportion Included in

Decision Number of Total (%) Subsequent Analysis

Took cash when savings plan completed 69 3.4 NoTook cash and some shares at exercise 26 1.3 NoExercised shares and divested immediately 215 10.4 Yes (13%)Exercised shares and divested within one year 507 24.6 Yes (31%)Exercised shares and retained for more than one year 909 44.2 Yes (56%)Exercised shares, sold some, and retained others 332 16.1 NoTotal 2,058 100 1,631

TABLE II


Orientations to SAYE

We proposed that the initial reasons for par-ticipation in SAYE would influence theactions taken by participants once optionshave been exercised. The results clearly bearout this proposition, as the addition ofINVOLVE and EXTRINSIC adds to therobustness of the model, and both are signif-icantly related to the sell/keep decision in allspecifications. Keepers are significantly morelikely to have entered SAYE for involvement-type reasons than are sellers. Conversely,keepers are significantly less likely than sell-ers to have participated for instrumental rea-sons (e.g., to make a quick profit). Theseresults add to those above indicating that

option plan participants behave consistentlyand rationally. Those individuals wanting tosave for a particular event or to make a quickprofit exit their shareholdings fairly soonafter exercise, whereas those for whominvolvement with the company is importantmaintain their involvement via medium-termshareholding. The extent of instrumentalityis the most important single influence (astepwise analysis indicates that this indicatorprovides the strongest contribution, as meas-ured by model chi-square). Overall, thesefindings indicate that orientations to a par-ticular set of share-option arrangements canbe more important than generalized riskpreferences in explaining what employees dowith the shares from their option plans.

Influences on the Decision to Retain Shares after Exercise

A Case in Point: Federal Information Technology Occupations

Logistic regressionVariable B Odds Ratio B Odds Ratio B Odds Ratio B Odds RatioFinance modelSAYE CONTRACTS –.127** .881 –.123* .884 –.091 .913 –.128* .880SALARY .100*** 1.105 .127*** 1.135 .101** 1.106 .046 1.047RISK PREFERENCE .256*** 1.292 .262*** 1.299 .137* 1.147 .095 1.099Step chi-square 80.22***

DemographicAGE .372*** 1.450 .339*** 1.403 .268*** 1.307SEX –.003 .997 –.037 .963 –.078 .925Step chi-square 37.028***

OrientationsINVOLVE .238*** 1.268 .225** 1.253EXTRINSIC –.590*** .554 –.541*** .582Step chi-square 90.783***

PortfolioEARLIER SHARE PLAN .869* 2.385DE-MUTUAL .654*** 1.922PRIVATIZATION .773*** 2.166SHARE PURCHASE .508*** 1.663PEP .464*** 1.590Step chi-square 126.781***

Company dummies Yes Yes Yes YesModel chi-square 80.222*** 117.850*** 208.633*** 335.413***Number of cases 1,538 1,538 1,538 1,5382 Log likelihood 2032.911 1995.883 1905.100 1778.320

Notes: * = significant at 0.05; ** = significant at 0.01; *** = significant at 0.001

TABLE III


Portfolio Diversification

The results for the portfolio diversificationanalysis are quite striking, as each variable(EARLIER SHARE PLAN, DE-MUTUAL,PRIVATIZATION, SHARE PURCHASE) issignificantly related to the sell/keep decision,confirming that those who retain shares alsohave more alternative, share-based invest-ments than those who sell shares. The addi-tion of this set of variables generates a sub-stantial improvement to the model, as shownby the change in chi-square. Forty-six per-cent of those selling their SAYE shares haveno other investments, whereas only 19% ofkeepers have no other form of share-basedinvestment. Fifty percent of keepers havetwo or more share-based forms of investmentother than their SAYE stock, compared withonly 22% of sellers. On the whole, keepersretain their shares as part of a diversifiedportfolio, whereas others appear to avoid anunbalanced portfolio by divesting their SAYEstock shares. These results are consistentwith the implications from portfolio theorythat employee share plan participants behavein broadly rational ways.

Controls

The company dummies are not significant,suggesting that there are no company-spe-cific factors that have a major bearing on thesell/keep decision.

Discussion and Conclusions

The results from the study are very clear-cut. Orientations to SAYE option plans andportfolio diversification have a strong influ-ence on whether participants in stock optionplans sell or retain the underlying stock onexercise. Age is also an important influenceon employee behavior. Portfolio rebalancing,as identified in earlier finance literature(Ofek & Yermack, 2000), also has an impact.Earnings initially have a strong influence onthe sell/keep decision, but this effect dimin-ishes when measures of orientations andportfolio composition are included. Thesame is true of risk preferences. The stronginfluences on retention behavior are notable

because they suggest that employees behaveas rational economic actors when decidingwhat to do with their stock options. They dowhat they set out to do, and they managetheir investment portfolios as they ought to.The finding that liquidity constraints aresomewhat less important when other factorsare taken into consideration is perhaps sur-prising given earlier literature (Huddart,1999; Huddart & Lang, 1996). This resultmight be explained by the fact that employ-ees opt into SAYE plans. Thus, in decidingthe level of options they want to subscribeto, employee liquidity constraints may be afactor at entry rather than exit. Certainly,the finding that the size of current optionplans is strongly correlated with income issupportive of this interpretation. However,any contrast with option plans characterizedby “automatic” grants should not be over-stated, since in most cases within the UnitedStates, the size of these are related toincome or similar factors using preset for-mulas (see Weeden et al., 2001, p. 18).

Our findings enrich the extant financeliterature on option exercises because theyprovide insights into employee behavior thatare obscured when the data source is imper-sonal share transactions rather than the indi-viduals making the transactions. The insightsgenerated by the current study are rather dif-ferent than those that have emerged fromthe finance literature. In the latter case, thegeneral perspective is that employee optionholders behave irrationally in the sense thatmost sacrifice much of the Black-Scholesvalue of their options by exercising (and sell-ing) early. This literature has thereforesought to explain why employees fail to pur-sue what appears to be in their best interests.By contrast, our findings suggest thatemployees behave in a way that is consistentwith their perceived interests, and further-more in accordance with investment princi-ples that would be seen as prudent byfinance scholars. The strongest message thatcomes from our research is that we need toknow what employees want from equity par-ticipation plans if we are to fully understandwhat they do with stock options and equityholdings. Formal valuation models in financedo not engage employee preferences to any

The results forthe portfoliodiversificationanalysis arequite striking,as each variable(EARLIERSHARE PLAN,DE-MUTUAL,PRIVATIZA-TION, SHAREPURCHASE) issignificantlyrelated to thesell/keepdecision,confirming thatthose whoretain sharesalso have morealternative,share-basedinvestmentsthan those whosell shares.


Whatcompanies getout of stockoption plans, interms ofemployeebehavior, maybe a function ofwhat they putin.

great degree (risk neutrality is normallyassumed). The implication of our findings isthat employee preferences may have a verysubstantial bearing on values attached tooptions and shares.

The finding that employee orientationsto option plans have a significant influenceon their stockholding behavior should per-haps not surprise us, but it nevertheless hasimportant implications for academicresearch and corporate practice. We distin-guish between the desire to secure financialbenefits and a concern to be involved in thecompany. Heterogeneity of employee orien-tations to share plans is to be expected, butthis possibility is often missed in studies ofthe outcomes of employee share plans. Theimplication of our results is that we only fullyunderstand the impact of share plans onemployee motivation and satisfaction if weknow where they are coming from and whatthey expect and want from the share plan (cf.Klein & Hall, 1988). Thus, employee prefer-ences should be incorporated to a greaterdegree in research in this area.

As for corporate practice, these findingsindicate that stock plans can have multiplemeanings among their workforce, and thatcompany managers cannot assume thatemployees perceive a single, or overriding,purpose to them. Equally, the findings implythat there could be a role for managers toinfluence employee orientations to stockoption plans. How a plan is packaged andpresented may affect employee orientations.At the very least, the results indicate thatmanagers cannot expect a set of “automatic”effects from option plans. What companiesget out of stock option plans, in terms ofemployee behavior, may be a function ofwhat they put in.

These findings have broader policy impli-cations. Contrary to the fears of some policy-makers in the United Kingdom, the resultsindicate that stock option plans can providean effective route into medium-termemployee share ownership. A key question iswhat conditions need to be satisfied for thismedium-term ownership to take place. Wecannot fully address this question in the arti-cle, although it should be considered infuture research. Possible factors include the

timing of tax liabilities and the state of thestock market. The factors that do emerge inthis study are individual-level ones, such asemployee orientations to the stock optionplan. For governments wanting to promoteemployee share ownership, this importantfinding suggests that the marketing of stockoption plans and financial education mightbe as important as tax arrangements (the pri-mary focus of governmental activity in thisarea). The results imply that the diffusion ofan employee culture that values involvementin the company, and an investment culturethat promotes diversified wealth portfolios,can contribute to the development of anemployee ownership culture.

The findings also counter the criticismthat tax-advantaged stock plans encourageliquidity-constrained employees to makemisguided investment decisions. This cri-tique argues that share plans encourageundiversified financial investments, and fur-thermore lead employees to concentratefinancial and human capital investments.Logically, the latter criticism cannot becountered by the study, but the findings indi-cate that the former is perhaps less of a prob-lem than has been thought. Those whochoose to retain shares are those best able todo so from a diversification point of view, andemployees seem to behave prudently in theirasset allocation decisions (at least within theinvestment parameters considered in thestudy).

However, looking at this study in abroader context suggests that tax regimesand the institutional contexts for equityplans are important. The absence of anincome tax liability at exercise in SAYE plans,coupled with the availability of savings planarrangements, clearly facilitates the holdingof shares after exercise. These factors mayhelp to explain why the level of retention iscomparatively high at over 40% of partici-pants. By contrast, the U.S. system typicallyrequires employees to finance their optionexercises themselves (except where loans andsavings plans are present), and thus simulta-neous exercise and stock sale is widespread(Anderson, 1999; Heath et al., 1999, Ofek &Yermack, 2000; Weeden et al., 2001). Thepresence of a tax liability at exercise (non-


qualified options) or the requirement for aholding period (in the case of incentive orqualified stock options) may add to liquidityproblems. It seems likely, therefore, that liq-uidity constraints would have been moredirectly important if this study had been con-ducted in the United States.

The limitation of this study is that we donot have precise data on the timing of sharesales and are unable to investigate preciselythe relationship between share price move-ments, volatility, and employee behavior.Thus, the strengths and weaknesses of ourresearch are the obverse of those of thefinance-based literature. Ideally, futureresearch should strike a middle coursebetween the two approaches. If the researchfocus is on all-employee plans, this need for amiddle course clearly will be problematic.Share register–based approaches to identify-ing the timings of option exercises/share salesprobably will not be feasible because of thewidespread use of nominee accounts. Evenwithout this problem, there is the ethical andpractical problem of matching share-registerinformation to information that would needto be collected directly from employees.Therefore, as in the current article, employ-ees themselves will probably need to be theexclusive source of data. Obtaining accuratedata on volumes and timing of share transac-tions will clearly pose some major problems.

Even so, further studies are clearly worthundertaking, since despite the importance ofshare-based rewards in countries like theUnited States and United Kingdom, we stillknow relatively little about the behavior ofparticipants in employee stock plans.

Acknowledgments

This research owes a large debt to severalpeople and organizations. The project wasfinanced by Halifax and Abbey NationalPLCs; Colin Kemp and Peter Robins wereinstrumental in organizing their respectiveorganizations’ support for the project. HelenHopkins and Sally Russell, then of theinvestor education and share ownership lob-bying group Proshare, organized the researchteam and facilitated the involvement of thecompanies in the research, while Diane Hayof the Inland Revenue facilitated my involve-ment in the project. Thanks are due also tothe share plan administrators in each of thecompanies who organized the distribution ofa large number of questionnaires. ObjectiveResearch did a great job in inputting the dataso quickly and accurately. I am grateful toJoseph Blasi, Jeff Hyman, participants in thePay Systems Study Group (organized by DanMitchell at the IRRA 2004 in San Diego),and two referees for very useful commentson an earlier version of the article.

Andrew Pendleton is a professor of human resource management at the Universityof York, United Kingdom. He has a BA (Honors) degree in philosophy, politics, andeconomics from the University of Oxford and a PhD in social sciences from the Uni-versity of Bath. He has written extensively on equity-based rewards and is the authorof Employee Ownership, Participation, and Governance (Routledge, 2001). He was amember of the U.K. government committee that designed two new tax-qualifiedemployee stock plans in 2000.

NOTES

1. No firms in the United Kingdom are known torequire that nonexecutive employees hold aportion of their income in stock or options. Infact, this would not be lawful with government-approved plans.

2. Huddart and Lang (1996) find that dividendsare not a significant determinant of exerciseactivity. Blasi et al. (2003) provide some cau-tionary evidence of what can happen whenemployees exercise and hold, especially involatile markets. See also Brandes, Dharwad-kar, and Lemesis (2003, pp. 79–80).


3. Weeden et al. (2001, p. 25) find that 8% ofcompanies with option plans provide loan assis-tance to employees.

4. The problem with qualified or incentive stockoptions for liquidity constrained, risk-averse,nonmanagerial employees is that the one-yearholding period post-exercise precludes sale ofoptions to meet the exercise price and exposesemployees to risk.

5. Participants elect at the outset whether to exer-cise at three or five years. At the chosen point,there is a six-month exercise “window.” Thoseselecting the five-year option may choose toretain the option beyond five years and exerciseat seven years.

6. This situation is, however, complex. The aver-age ratio of current savings contracts to annualsalary (calculated as the midpoint of each salarycategory) is 9%. In one firm, the ratio exceeds10%. This firm also has the lowest averagesalaries and the highest proportion of female,part-time employees. It is possible that thesmaller of household incomes are used dispro-portionately to take advantage of tax breaks.

7. Note that we do not use the terminology fromthe employee share ownership literaturebecause our involvement scale would beexpressed as “instrumental”—this usage wouldbe confusing given that our financial scalerecords instrumental behavior.

8. It is worth noting, however, that the size of con-tributions to Sharesave option plans is support-ive of a diminishing propensity to save whenclose to retirement, the oldest age cohort con-tributes less than any other age cohort.

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Exploratory Factor Analysis of Share Plan Orientation Variables

Principal component analysis: Varimax rotationFactor 1: Involve Factor 2: Extrinsic

To contribute to and gain from the company’s success .895 –6.092E-02To feel a greater involvement in the company .898 –4.789E-02To save for a particular event 9.758E-02 .826To make a quick profit –3.862E-02 .834Percentage of variance 40.435 34.502Eigenvalue 1.617 1.380

APPENDIX B

Sellers or keepers? Stock retentions in stock option plans

Documents

Transcript of Sellers or keepers? Stock retentions in stock option plans