Managerial Performance Incentives and Firm Risk During Economic Expansions and Recessions

In our article, Managerial Performance Incentives and Firm Risk during Economic Expansions and Recessions, which is forthcoming in the Review of Finance, we show that the relationship between managerial pay-for-performance incentives and risk taking is pro-cyclical.

A significant portion of executive pay packages are in the form of equity-based compensation, which create 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 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.

There is growing evidence illustrating that the individual risk aversion coefficients increase during recessions (Guiso et al., 2014; Cohn et al., 2014). In addition, managerial wealth is expected to decrease during recessions (Davis and von Wachter, 2011; Farber, 2011; Guvenen, 2014). Both the increase in risk aversion coefficients 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.

In order to test this hypothesis, we assemble a panel dataset on executive compensation of the chief executive officers (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 provided by stock and stock option grants, which amount on average to 37 percent of a CEO’s pay during our sample period. We measure the sensitivity of a CEO’s wealth to firm performance with delta—the change in the dollar value of a CEO’s wealth for a one percentage point change in the stock price (Core and Guay, 2002). We also control for risk taking incentives provided to the managers through stock option compensation.

Using the business cycle dates identified by the NBER, we show that the relationship between pay-for-performance incentives and firm risk is positive during economic expansions. However, we observe no significant relationship between pay-for-performance incentives and firm risk during recessions. To state the impact of the recession periods in economic terms, we calculate the effect of increasing a CEO’s delta from its 25th percentile value ($49,000) to its 75th percentile value ($403,000). Such an increase in CEO incentives is associated with a 16 percent increase in firm risk during the expansionary periods, while it has virtually no effect on firm risk during the recession periods. This result is robust to using alternative measures of macroeconomic state as well as to estimation with instrumental variables and simultaneous equation regressions to account for the endogenous nature of compensations contracts (Murphy, 2012).

The ability of the managers to adjust the firm’s overall risk profile over a short period of time should vary across firms. Therefore, the paper’s main prediction should be more applicable when a manager can alter the firm’s risk profile more. Accordingly, we look into the instances when CEOs have more control over firms’ resources. CEO tenure and product market competition have been widely used as a proxy for CEO control in the literature (e.g., Bebchuk et al., 2010; Ferreria et al., 2011; Giroud and Mueller, 2010; Chhaochharia et al., 2012). Using these measures of managerial control, we show that the relationship between firm risk and delta weakens more in recessions for firms that are managed by more powerful CEOs.

Overall, our results suggest that the same manager with exactly the same level of performance incentives facing the same firm characteristics may target a lower (higher) risk level during economic recessions (expansions). Understanding how similar pay packages are associated with different risk levels under different economic conditions is crucial for designing compensation packages that yield a desired level of firm risk over the business cycle. A large set of corporate finance studies argues that excessive risk aversion on the part of CEOs and other senior executives is one of the most important and potentially most costly agency problems. In theory, shareholders and boards, who are well aware of the significance of this agency issue, can design contracts to mitigate executives’ risk aversion. However, in practice, the contracts designed by the boards may not always sufficiently incentivize the executives to offset the effect of increasing risk aversion during recessions. Equally, not considering the effect of lower risk aversion levels during economic booms might result in managers taking excessive risks, as evidenced in the last financial crisis.

Our research highlights the importance of the interaction between managerial incentives and the macroeconomic environment. Boards and regulators, who design compensation structure to curb excessive risk taking, may find it useful to consider the pro-cyclical nature of the relationship between performance incentives and risk taking. Our results indicate that counteracting the pro-cyclical relationship between pay-for-performance incentives and firm risk by providing less (more) risk taking incentives during economic expansions (recessions) can be beneficial.

The complete publication is available here.