Executive Overconfidence And Compensation Structure
UNSW Business School; Financial Research Network (FIRN)
George Mason University
Vikram K. Nanda
University of Texas at Dallas – School of Management – Department of Finance & Managerial Economics
Sabatino Silveri
University of Memphis – Fogelman College of Business and Economics
May 2015
Journal of Financial Economics (JFE), Forthcoming
Abstract:
We examine the impact of overconfidence on compensation structure. We test alternative hypotheses, drawing upon and extending existing theories. Our findings support the exploitation hypothesis: firms offer incentive-heavy compensation contracts to overconfident CEOs to exploit their positively-biased views of firm prospects. Overconfident CEOs receive more option-intensive compensation and this relation increases with CEO bargaining power. Exogenous shocks (SOX and FAS 123R) provide additional support for the findings. Overconfident non-CEO executives also receive more incentive-based pay, independent of CEO overconfidence, buttressing the notion that firms tailor compensation contracts to individual behavioral traits such as overconfidence.
Executive Overconfidence And Compensation Structure – Introduction
We investigate whether overconfidence affects the compensation structure of CEOs and other senior executives. There is a burgeoning literature on the impact of CEO overconfidence on corporate policies. Overconfident CEOs are prone to overestimate returns to investments and to underestimate risks (Dittrich et al., 2005; Malmendier and Tate, 2005, 2008; Kolasinski and Li, 2013).1 Little is known, however, about the nature of incentive contracts offered to overconfident managers or even whether firms “fine-tune” compensation contracts to match a manager’s personality traits. We help fill this gap.
While we expect compensation contracts to differ for overconfident managers relative to rational managers, the nature of these differences is not obvious. On the one hand, an overconfident manager might need weaker incentives in the form of options or restricted stock given the higher probability the manager associates with a successful outcome. With their positively-biased view of future firm prospects, a smaller equity stake might be sufficient to induce overconfident managers to deliver the required effort or to make the appropriate decisions.2 It is also possible for strong incentives to be counterproductive as such incentives could exacerbate risk-taking by an already overconfident manager. We refer to this as the weak-incentive hypothesis, which predicts a negative relation between overconfidence and the proportion of incentive-based compensation a manager receives.
On the other hand, as Gervais, Heaton and Odean (2011) [hereafter GHO] argue, it can be optimal to offer incentive-intensive contracts to overconfident CEOs.3 Their insight is that if an overconfident CEO places a sufficiently high probability on good outcomes, it is relatively inexpensive for the firm to offer a compensation package with high option and stock intensity. Hence, at the margin, the purpose of an incentive-heavy compensation contract is to take advantage of the CEO’s misvaluation rather than to provide incentives. We call this the exploitation hypothesis, which predicts a positive relation between overconfidence and the proportion of incentive-based compensation a manager receives.
A question, though, is whether the only reason to give overconfident managers incentive-heavy compensation contracts is to exploit their overvaluation. We develop an alternative hypothesis, based on a simple extension of GHO’s model, to show that the need to provide incentives – rather than exploitation – can also lead to overconfident managers receiving greater incentive-based compensation. The reason is that some incentives are only worth providing by the firm when the CEO is overconfident and that, when this is the case, stocks and stock options serve mainly to align the CEO’s incentives with those of the firm’s shareholders. That is, additional options are only provided to CEOs who are known or are expected to be overconfident. We refer to this as the strong-incentive hypothesis.
We conduct empirical tests to explore the relation between CEO overconfidence and incentive compensation and to differentiate among the three hypotheses (weak-incentive, exploitation, and strong-incentive hypotheses). We use the compensation data of CEOs between 1992 and 2011 to create option-based measures of overconfidence.4 These measures are premised on the idea that a manager’s human capital and compensation are tied to the company, rendering the CEO undiversified. Consequently, a rational CEO exercises deep in-the-money options as soon as they vest. Thus, holding deep in-the-money options indicates overconfidence. Our results are robust to using media-based measures of overconfidence.
Consistent with both the exploitation and the strong-incentive hypotheses, but not with the weak-incentive hypothesis, CEO overconfidence increases both option and equity intensity, measured as the proportion of total compensation that comes from option and equity grants, respectively. We also find some evidence that overconfident CEOs receive even greater option and equity intensity in innovative and risky firms.
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