It’s been an urgent question since the start of the Great Recession: does equity-based CEO compensation encourage excessive risk taking? Or is it a useful incentive for taking necessary risks?
Hundreds of studies have yielded no clear answer. Our research refines a theory from the 1990s, demonstrating that equity pay can both encourage and discourage risk-taking: a CEO’s potential gains from options (prospective wealth) increase risk taking, while growth in the value of accumulated holdings (current wealth, which can be lost) curbs the appetite for risk. The effect that prevails depends on the mix of the two. Boards should manage this mix to encourage behaviour that’s best for their company.
We examined compensation and financial data for publicly-traded US manufacturing firms from 1996 to 2009, for a total of 9,143 CEO-year observations. We calculated an indicator of strategic risk taking on the basis of R&D and capital expenditures and long-term debt, and used it to rate each CEO’s propensity for risk. We also calculated the current value of each CEO’s holdings and the prospective value if options prices increased at the average market rate.
Our analysis allowed us to quantify how prospective and current wealth affect risk taking. For each standard deviation increase in prospective wealth, we found, annual risk taking rises by about 33%, and for each standard deviation increase in current wealth, it falls by 18%.
Boards should be aware of these effects and realise that the risk-taking calculus for a CEO can change dramatically over time, owing to stock price changes or new grants. CEOs are more likely to take big risks early in the life of their stock options, when current wealth is low and prospective wealth is high; the same executives may be much more cautious years later if they have more accumulated wealth to protect.
We suggest that instead of issuing stock and options in predetermined quantities over a CEO’s tenure, boards should vary grants so that risk incentives align with the firm’s strategic plans. The optimal gain-to-loss ratio will depend on factors such as industry, product life cycle and stakeholder risk appetite. Behavioural research shows that a gain-to-loss ratio of about 2-to-1 is the average threshold for willingness to take risks. This is a useful benchmark for a board seeking to ensure that its CEO’s equity does not encourage destructive risk taking (above a 2-1 ratio) or discourage value-enhancing risk taking (below a 2-1 ratio).
Issuing stock rather than options at the outset is a sound choice for firms desiring a conservative approach. Boards that hope to innovate or expand should bear in mind that executives with valuable accumulated holdings may be reluctant to execute those plans. In extreme cases, long-tenured CEOs with large holdings may be so inclined to play it safe that directors might consider speeding up the succession plan to bring in a boss with less to lose.
Geoffrey Martin is a senior lecturer in strategy at Melbourne Business School. Luis Gomez-Mejia is the Benton Cocanougher Chair in Business at Texas A&M Business School. Robert M. Wiseman is the head of the management department at Michigan State University’s Eli Broad College of Business.