CEO incentives should be more strategic

CEOs are sometimes rewarded for taking excessive risks – a practice that helped fuel the recent recession but could be altered if companies are more strategic in how they compensate their chief executives, a Michigan State University scholar argues in a new study.

Instead of issuing stock and stock options in predetermined quantities, boards of directors should vary a CEO’s equity-based compensation through a plan that fosters the amount of risk-taking the firm desires, said Robert Wiseman, chairperson and professor in MSU’s Department of Management.

The vast majority of chief executive officers of public companies receive stock and stock options, and often that equity pay makes up more than half of their total compensation. As the person in charge, a CEO makes the final decision on potentially risky ventures such as whether to acquire or merge with another company.

“I would argue that the CEO incentive structure encouraged the excessive risk-taking that played a strong role in the recession,” Wiseman said. “So managing risk preferences though compensation is something that should be on the agenda of any company’s board of directors.”

For the study, Wiseman and colleagues Geoffrey Martin of Melbourne Business School and Luis Gomez-Mejia of Texas A&M University examined CEO compensation and financial data for publicly traded manufacturing firms from 1996 to 2009.

When it came to CEOs’ equity pay, the study analyzed current wealth – or how much the stock and stock options would be worth if cashed out today – and prospective wealth, or how much more the equity would be worth at its expiration date, typically years down the road.

Chief executives who had three times as much prospective wealth as current wealth were more willing to take potentially destructive risks. Those with roughly the same amount of current wealth and prospective wealth were less inclined to take such risks, ostensibly because they feared losing the sizable amount they had earned, Wiseman said.

A useful benchmark for companies looking to encourage value-enhancing risk-taking is about 2 to 1 – or about twice as much prospective wealth as current wealth, the researchers said. In other words, a CEO who has $20 million in prospective wealth and $10 million in current wealth will likely take risks aimed at growing the company sensibly.

The findings challenge the current mindset guiding most compensation plans – that stock options carry no risk for chief executives. But Wiseman argues that CEOs do, in fact, consider stock options when calculating their personal wealth, particularly as the options grow in value. Thus, equity pay should be issued more strategically.

“If a firm’s board of directors wants to influence the CEO’s risk-taking behavior, it should consider changing how it rewards that CEO,” Wiseman said. “Simply imitating what every other company is doing – like issuing a predetermined number of stock options semi-annually or annually – may not necessarily be the right thing to do.”

The study will appear in a forthcoming issue of the Academy of Management Journal. A version also appears in the October issue of Harvard Business Review.

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