Managerial Performance Incentives And Firm Risk During Economic Expansions And Recessions

Tanseli Savaser
Bilkent University, Faculty of Business Administration

Elif Sisli Ciamarra
Brandeis University

August 6, 2014


We argue that the relationship between managerial pay-for-performance incentives and risk taking is procyclical. We study the relationship between incentives provided by stock-based compensation and firm risk for U.S. non-financial corporations over the two business cycles between 1992 and 2009. We show that a given level of pay-for-performance incentives results in significantly lower firm risk when the economy is in a downturn. The documented procyclical relationship between incentives and risk taking is consistent with state-dependent risk aversion. Our findings contribute to the literature on the depressive effects of performance incentives on firm risk by documenting the importance of the interaction between performance incentives and risk aversion.

Managerial Performance Incentives And Firm Risk During Economic Expansions And Recessions

A significant portion of pay packages of high level executives are in the form of equity-based compensation. Compensation tied to equity creates pay-for-performance sensitivity and is expected to incentivize managers to exert effort and take actions that increase stock values. However, the relationship between pay-for-performance incentives and firm risk is less clear. Pay-for-performance sensitivity could induce more risk taking because risky projects generally create more value and therefore increase the expected value of incentive compensation. However, it could also induce less risk-taking because of a desire to limit portfolio risk. This is mainly because managers are inherently more risk averse than diversified shareholders due to their organization-specific human capital and/or undiversified wealth portfolios (Smith and Stulz, 1985; Amihud and Lev, 1981; Tufano, 1996).

Despite the well-developed theoretical literature stressing the depressive effects of managerial performance incentives on risk taking, the number of empirical papers testing this argument remains limited. While existing studies have focused primarily on the variation in incentive compensation, it is a combination of incentive compensation and managerial risk aversion that should impact the relationship between performance incentives and firm risk. In this paper, we test the theory exploiting the variation in both incentive compensation and managerial risk aversion. We argue that risk aversion is higher during recessions. There is growing evidence illustrating that the individual risk aversion coe¢ cients increase during recessions (Guiso et al., 2014; Cohn et al., 2014). In addition, managerial wealth is ex- pected to decrease during recessions (Davis and von Wachter, 2011; Farber, 2011; Guvenen, 2014). Both the increase in risk aversion coe¢ cients and the decrease in managerial wealth are expected to translate into lower risk appetite for a given level of performance incentives. Therefore, we propose and test a joint hypothesis that managerial risk aversion increases during recessions and that the increase in risk aversion leads to a weaker relationship between managerial performance incentives and risk taking.

Managerial Performance

In order to test this hypothesis, we assemble a panel dataset on executive compensation of the chief executive o¢ cers (CEOs) of the U.S. public firms between 1992 and 2009, a period that covers two macroeconomic recessions as determined by the National Bureau of Economic Research (NBER). We calculate the CEO performance incentives, which are provided by stock and stock option grants. These grants form a significant portion of the executive pay packages, amounting on average to 37 percent of a CEO’s pay during our sample period.

We measure CEO performance incentives by delta — the change in the dollar value of a CEO’s accumulated stock and stock options for a one percent change in the stock price (Core and Guay, 1999; Coles et al., 2006). Since the primary focus of our paper is the relationship between pay-for-performance incentives and firm risk, we emphasize the results regarding the effect of delta, but we also control for risk taking incentives provided to the managers through stock option compensation. Controlling for risk taking incentives is important because of the possibility that stock options that managers hold may slide out of the money during recessions, diminishing the risk taking incentives of managers. We measure risk taking incentives by vega — the change in the dollar value of a CEO’s wealth for a 0.01 change in the annualized standard deviation of stock returns (Core and Guay, 1999; Coles et al., 2006).

Managerial Performance

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