CEO Compensation and Corporate Risk-Taking: Evidence from a Natural Experiment
Gormley, Todd, and Todd Milbourn
This paper examines the relationship between managerial compensation and corporate risk-taking in light of an unanticipated increase in firms’ business risks—specifically, an increase in liability and regulatory risk arising from workers’ exposure to newly identified carcinogens. This natural experiment provides an opportunity to examine two classic questions related to incentives and risk—how boards attempt to adjust incentives in response to firms’ risk and how these incentives affect a manager’s risk-taking incentives. We find that, after risk increases, boards reduce managers’ exposure to their firms’ risk, but managers’ total compensation portfolios remain relatively sticky for several years. We examine how managers’ ex-ante incentives affect real corporate risk choices in this period. We find that less convexity from options-based pay leads to greater risk-reducing activities that lower the variance of stock returns. Specifically, managers with less convex incentives tend to cut leverage and R&D, stockpile cash, and engage in more diversifying acquisitions.
Gormley, Todd, and Todd Milbourn. 2013. CEO Compensation and Corporate Risk-Taking: Evidence from a Natural Experiment. Journal of Accounting and Economics. 56(2-3): 79-101.