Executive Overconfidence and Compensation Structure

In our paper “Executive Overconfidence and Compensation Structure,” forthcoming in the Journal of Financial Economics, 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. 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. Strong incentives can also be counterproductive if they 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. 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. 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. These measures, developed in Malmendier and Tate (2005), 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 complement the CEO-level results with evidence on the compensation of overconfident non-CEO executives. We hypothesize and find that overconfidence impacts non-CEO executive compensation in a similar manner to which it impacts CEO compensation. This is an important finding since it indicates incentive compensation for CEOs and non-CEO executives is being driven by the same economic rationale, reflecting individual traits and not merely firm-level characteristics.

We next conduct tests to differentiate between the exploitation and the strong-incentive hypotheses. In particular, we first examine the impact of CEO bargaining power. As discussed in GHO, under the exploitation hypothesis an increase in compensation resulting from an increase in CEO bargaining power will take the form of more options-based pay. On the contrary, the strong-incentive hypothesis predicts a decrease in option intensity: as incentive conditions are satisfied and, with risk-averse overconfident CEOs valuing options less than the firm (but more than their rational counterparts) any additional compensation takes the form of cash. We find empirically that the positive relation between overconfidence and option intensity increases with CEO bargaining power, consistent with the exploitation hypothesis but not the strong-incentive hypothesis.

We then use the passage of the Sarbanes-Oxley Act of 2002 (SOX) as an exogenous shock to also help differentiate between the exploitation and the strong-incentive hypotheses. Given increased board monitoring post-SOX, if incentive compensation and board monitoring are substitute governance mechanisms, then firms will lower the option intensity of compensation contracts. However, under the exploitation hypothesis, options-based pay at the margin is used to exploit CEO overconfidence. Hence, there is reduced scope to substitute option compensation with monitoring. We find that the reduction in option intensity post-SOX is less severe for overconfident CEOs, consistent with the exploitation hypothesis.

We also use the passage of FAS 123R as another natural experiment to differentiate between the exploitation and the strong-incentive hypotheses. FAS 123R requires firms to report options-based compensation at fair value on their income statement, thus rendering options-based compensation more expensive from an accounting perspective. We find that, while the percentage decrease in option intensity is similar for overconfident and rational CEOs, the dollar amount of cash and stock compensation increases more for overconfident CEOs post-FAS 123R. This is again consistent with the exploitation hypothesis as under this hypothesis the CEO places a greater value on options than the firm does, so a reduction in option pay requires the firm to give the CEO a relatively larger offsetting increase in cash and stock compensation.

Our analysis of overconfidence and compensation contributes to the literature in several ways. Supporting the theoretical arguments in GHO, we show empirically that overconfident managers receive greater option and equity intensity than do their rational counterparts. As Malmendier et al. (2011) point out, it is imperative for boards to calibrate incentives to account for behavioral traits. Our results suggest that firms “fine-tune” their contracts to match personality traits such as overconfidence.

More broadly, our results indicate that the beliefs and behavioral traits of managers introduce significant heterogeneity in the contracting between firms and managers. This is an interesting and important area for future research. For instance, there may be a concern that in an industry that attracts many overconfident managers, offering strong incentives could exacerbate the problems of excessive investment and risk-taking. However, to the extent that strong incentives are used to exploit rather than incentivize overconfident managers, our results suggest such a concern may not be justified and calls into question the necessity, or desirability, of regulating incentive pay.

The full paper is available for download here.