Stock options are not suitable for present value calculation.
By Mark K. Altschuler,Actuary
In an issue of national interest, the Pennsylvania Supreme Court in Fisher v. Fisher [769 A.2d 1165 (Pa. 2001)] held that employee stock options are not suitable for present value calculation and recommended deferred distribution. Since employee stock options are normally non-transferable, any domestic relations order would be on an as if when basis, with the employee spouse paying the nonemployee spouse his or her share when the option is executed. Thus, the domestic relations order amounts to a contract between the parties binding them after the divorce. This is very different from a qualified domestic relations order (QDRO), where the order is served on the plan, not on the employee, and the parties are separated. Even though the court discussed the fact that binding the parties is not desirable, it decided that immediate offset did not apply for stock options, since execution of the option is merely an expectation without a real value.
Comparison to Pensions
The nonemployee spouse (wife) argued that unvested stock options are similar to an unvested pension and may be valued as such. In Pennsylvania, a pension may still be present valued even if not vested. There are, however, many issues besides vesting in terms of the valuation of stock options. In essence, a stock option is much more speculative than a pension, and this is why the Pennsylvania Supreme Court found the options to be an expectation. Even if the stock options were vested, there still is an assumption of future service in the valuation of stock options. This is due to the nature of stock options. The option has an expiration date after which it cannot be exercised. It also has a strike price at which the owner buys the stock under the options. If the stock price exceeds the strike price before the expiration date, the option can be exercised by selling the stock, assuming the strike price exceeds the strike price of the option. The Black-Scholes algorithm (mathematical method) uses the expiration date, the current price, the strike price, and the stock volatility (amount of fluctuation) to arrive at the Black-Scholes value of the option. The higher the Black-Scholes value, the more likely the stock is to exceed the strike price before the expiration date. Thus, applying the Black-Scholes algorithm to an employee stock option assumes that the employee will stay with the company until the expiration date of the option. If the employee leaves, he or she forfeits the option.
This is not the case with pensions. If the normal retirement age is used in the pension valuation, there is no assumption of future service. The normal retirement age is the earliest age that the unreduced pension is payable based on service as of the date of valuation. Thus, there is no assumption of future service. If an earlier retirement age is used based on future service (for example, attainment of 35 years of service with the Public School Employees Retirement System), the valuation is speculative. The Actuarial Standards Board recommends use of plan turnover statistics so that the probability of future service can be taken into account. Thus, there is no need to assume future service in a pension valuation, whereas the stock option valuation must assume future service. Since the plan turnover statistics are rarely available, this factor alone inflates the result compared to a pension valuation. In order to be accurate, the value of the stock option would have to be multiplied by the probability of future service.
Beyond the issue of future service, a stock option is a much more speculative financial instrument than a pension or annuity. For this reason, the majority of the Pennsylvania Supreme Court found that an employee stock option is merely an expectation, like an inheritance, and only has value when actually executed. Thus, the majority found in favor of deferred distribution. However, a dissenting opinion discussed the Black-Scholes method of stock option valuation and reasoned that this method could be used for valuing employee stock options. However, when using the Black-Scholes method in valuing publicly traded stock options, there is no assumption of future service, such as in employee stock options. Ignoring this factor, the value of a stock option under Black-Scholes is still not equivalent to the present value of a pension for reason explained below.
A pension offered by an employer is equivalent to an annuity that individuals can buy from a life insurance company. The present value of the pension, discounting for interest and mortality, represents the market value of the pension (neglecting overhead and profit loading). Middle class people with conservative investment strategies often buy such annuities for retirement. The only speculation is the individual’s longevity. Their “bet” has little risk. If the individual lives to be 100, the worth of the annuity will turn out to be much greater than the purchase price. If the individual dies a year after the commencement of the annuity, he or she will not need the money anyway. Thus, if passing on an inheritance is not a factor, there is no downside to the risk aspect of a pension. A rational middle class person may spend a considerable amount of money to purchase an annuity from a life insurance company. Thus, the present value of a pension represents a true market value. In addition to this, pensions offered to employees by private companies are guaranteed by the Pension Benefit Guarantee Corporation, even if the company goes out of business. This adds another layer of security to the pension compared to an annuity offered by a bank or life insurance firm.
This is a very different case from stock options. No rational person of moderate means would put a significant portion of retirement income into stock options. Investing in stock options is on a bet what you can afford to lose basis. Most people active in options trading are professional traders. In fact, if an option has a high Black-Scholes value, this does not mean at all that the stock has been doing well and is likely to exceed the strike price before the option expires. All it means is that the stock has been volatile with a lot of fluctuation. It is just as likely that the stock price will go down. In order to explain this, it is first necessary to review a bit of option terminology.
Call and Put Options
A call option, the type of options given to employees, is predicated on the stock price rising. When executing the option, the trader sells the stock at the time of executing the option and buys the stock at the strike price. If the price at time of execution is higher than the strike price, the trader makes money. In a put option, the trader buys the stock at the time of executing the option and sells at the strike price. Thus, the trader makes money if the stock goes below the strike price. Suppose the stock is currently at $60. Now consider a call option with a strike price of $80 and an expiration date of December 2002. Suppose the call option for stock A has a Black-Scholes value of $5 per share and the call option for stock B has a Black-Scholes value of $10 per share. This does not mean at all that stock B is likely to do better in the future than stock A. A put option with a strike price of $40 ($20 down instead of $20 up) will have a Black-Scholes value close to $10 for stock B and close to $5 for stock A. The stocks are almost as likely to go down as up in the Black-Scholes model. The only difference in the Black-Scholes values for the two stocks is that stock B has been more volatile with more price fluctuation. Thus, while Black-Scholes does reflect the market value of an option, in most cases it has nothing to do with how well a stock has performed and is likely to perform in the future. Figure 1 illustrates the situation with stock A and stock B.
|Price of Call Option||Price of Put Option|
|Current Price||Strike Price=$80||Strike Price=$40|
|Stock A $60||$5.00||close to $5|
|Stock B $60||$10.00||close to $10|
Consider the following real life example. On November 29, 2001, the price of Qualcomm was $57.83. The Black-Scholes value of a call option with a strike price of $60($2.17 up) was $8.15, while the Black-Scholes value of a put option with a strike price of $55($2.83 down) was $6.59. Both options had an expiration date of August 2002. Since the put option had a little further to go to be “in the money,” it was worth less. If the stock were at $57.50, the options would be symmetric ($2.50 either way to be “in the money.”) The two options would then be very close to the same value. Thus, the Black-Scholes value for a put option with a strike price $20 below the current price will be very close to the Black-Scholes value of a call option with a strike price $20 above the current price, as in the hypothetical. Stock B is more likely to go up, and it is also more likely to go down than Stock A under Black-Scholes.
An interesting bit of history underscores the fact that the Black-Scholes value has little to do with future stock performance. The economists who created Black-Scholes won the Nobel prize for economics but started an investment firm that lost billions of dollars.
Now consider the implications of this. An employee with a poorly performing company with a poor earnings record could have a Black-Scholes valuation of twice that of a better company with a good earnings record if the poorly performing stock had a more volatile history. In addition, Black-Scholes is more applicable to stocks with large market capitalization than stocks with small market capitalization. This is because the Black-Scholes method is based on an assumption of randomness that may not hold for a small company with low trading volume. Thus, the Black-Scholes method usually will be close to the market value for a Microsoft or GE but may not be applicable for a small company. For example, the Black-Scholes values quoted above for Qualcomm were close to the actual market values on November 29, 2001. The Black-Scholes value for a small company may be far from the market value.
This is just common sense statistics. If you flip a coin only a few times, one would not expect to get half heads and half tails. In addition, even for a company with large trading volume, the Black-Scholes value may in some cases be far from the market value, since the Black-Scholes algorithm will not take into account recent news or investor sentiment. Thus, for a small company, the Black-Scholes value may be entirely unreflective of market value.
If the option is executed and does not give the spouse her share, recourse is a breach of contract action.
Assuming a stock that was trending in a straight line as a hypothetical. Suppose the stock has been increasing at $20 per year and will increase in the future at $20 per year. If the current price of the stock is $60 and the strike price is $70, a call option with an expiration date of exactly one year from today has a value of $10 (assuming the stock has no dividend yield and ignoring discounting with interest). With perfect knowledge, the option can be executed in one year for a profit of $10 per share since the stock will be at $80 in one year and the strike price is $70. Yet, the Black-Scholes value of this option will be near zero because the stock has almost no volatility, while the option is worth $10.
Remember that the Black-Scholes value for a call option (stock going up) will be close to that for a put option (stock going down). The Black-Scholes method is not based on stock performance. The stock with the higher Black-Scholes value has more volatility and actually may be the poorer performer. Conversely, the example above uses an idealized stock with predictable performance and has a near zero Black-Scholes value. Thus, a stock option is an inherently very speculative investment. A rational person of middle class means will equate a $20,000 purchase price of an annuity from a life insurance company with cash on hand of $20,000 and buy the annuity. No rational person would make the same decision with stock options unless the $20,000 was very small compared to the person’s income. The present value of $20,000 of the annuity is truly what the annuity is worth in the market to the average person. The Black-Scholes value of stock options will be close to the market value for stocks with high trading volume. However, this is only a value to traders, not the average person. For a stock with low trading volume, the Black-Scholes value may not even reflect the market value.
When the annuity is granted in the form of a pension to an employee, the present value of the pension represents the purchase price of the pension in the open market (ignoring profit loading and overhead) from a life insurance company. The same individual could buy the same annuity from a life insurance company. If the employee is granted stock options from a company, the Black-Scholes value may be distorted if it is a small company with low trading volume. Even if the company is large and the Black-Scholes value is accurate, the average person will not make the same investment decision with the stock options and would be foolish to do so.
The Black-Scholes method has an application, however, even in a deferred distribution scenario. Since the options are usually nontransferable, the domestic relations order in a deferred distribution is a contract between the parties. If the employee spouse executes the option and does not give the nonemployee spouse his or her share, the only recourse is a breach of contract lawsuit. Thus, the Black-Scholes value can be put in the order as a judgment note for the protection of the nonemployee spouse in case of default by the employee spouse. Also, if both parties agree, it can be used as a settlement tool to avoid binding the parties in the future. However, in general, the view of courts such as Pennsylvania’s that stock options are more speculative than pensions is the correct one.
Mark K. Altschuler, Actuary, is President of Pension Analysis Consultants, Inc., (PAC®) of Elkins Park, PA. He has performed over 25,000 pension valuations and QDROs. He has spoken about this and other topics at state and local bar associations and CLE workshops. His affiliations include the American Society of Pension Actuaries and Professionals (ASPPA) and the American Academy of Economic and Financial Experts. Mr. Altschuler writes a nationally distributed newsletter on pension issues in divorce (DIVTIPS®) and is a contributing author to the books, Valuing Specific Assets in Divorce and Valuation Strategies in Divorce: Aspen Publishers/WoltersKluwer, New York.
This article originally appeared in Vol. 16, No. 4 American Journal of Family Law Winter 2002, (Aspen Publishers/Wolters Kluwer Law & Business), a premier publication with professional articles for practicing matrimonial lawyers. Reprint with permission.