How Important Are Risk-Taking Incentives in Executive Compensation?

1. How Important Are Risk-Taking Incentives in Executive Compensation? Ingolf Dittmann Ko-Chia Yu Erasmus University Shanghai University of Rotterdam Finance and Economics How Important are Risk-Taking Incentives in Executive Compensation

2. Motivation:Relation between risk and incentives • Informativeness principle (standard agency theory): • More risk  less incentive pay • Mixed empirical evidence (Prendergast, 2002) Firm Risk CEOincentives How Important are Risk-Taking Incentives in Executive Compensation

3. Motivation:Relation between risk and incentives • Solid evidence that CEOs respond to risk-taking incentives • Hedging: Tufano (1996); Knopf et al. (2002) • Investments: Rajgopal and Shevlin (2002) • Leverage: Coles et al. (2006), Tchistyi et al. (2007) • Acquisitions: May (1995), Smith and Swan (2007) • Stock and bond holders anticipate CEO risk-taking: DeFusco et al. (1990), Billett et al. (2006) Firm Risk CEOincentives How Important are Risk-Taking Incentives in Executive Compensation

4. Research question • Do shareholders provide risk-taking incentives on purpose? • Or are risk-taking incentives just an unimportant side effect of effort incentives? • Is it important to take into account risk-taking incentives when designing a CEO compensation package? How Important are Risk-Taking Incentives in Executive Compensation

5. Approach • We model the endogeneity between risk and incentives • Principal-agent model • Effort-averse agent chooses effort and firm strategy. • Firm strategy affects firm value and volatility. • Incorporate informativeness and risk-taking incentives • Calibrate the model to individual CEO data. • Model predicts • Optimal compensation structure for each CEO • Savings firms could realize by switching • Compare model predictions with observed contracts • Better than a model without risk-taking incentives? How Important are Risk-Taking Incentives in Executive Compensation

6. Results (1)Consistence with compensation practice Savings from recontracting are small (mean: 10.4%) Average distance between the observed contract and the predicted contract is small. (mean: 8.0%) Much better fit than models with effort aversion alone Dittmann & Maug (2007) find up to 54% savings and 28.8% difference in distances Conclusion: Risk-taking incentives play an important role in executive compensation practice. How Important are Risk-Taking Incentives in Executive Compensation

7. Results (1)Consistence with compensation practice How Important are Risk-Taking Incentives in Executive Compensation

8. Results (2)Application: In-the-money options are optimal • Replace stock & ATM options by ITM options W  observed • Small savings optimal   P • If U.S. taxes are taken into account: • Observed contract is optimal for 93% of the CEOs • Results consistent with the universal use of at-the-money options How Important are Risk-Taking Incentives in Executive Compensation

9. The model:Standard assumptions • Time t = 0: Contract is signed. • Time T: End-of-period stock price PT is realized and wage w(PT) is paid. • Immediately after t = 0, the agent chooses effort e. • Firm value E(PT) is increasing and concave in e. • Agent incurs costs of effort C(e) that are increasing and convex in e. • Stock price is lognormally distributed. • Agent is risk-averse (CRRA-parameter γ). How Important are Risk-Taking Incentives in Executive Compensation

10. The model:Additional assumptions • In addition to effort, CEO chooses firm strategy s. • Combination of many different actions (e.g., project choice, M&A, financial transactions) • Affects firm value E(PT) and firm risk σ. • Risk-averse CEO with monotonic wage contract will choose a strategy (s) that maximizes E(PT) given σ. • Choice of s is equivalent to choice of σ. • Reduced form: assume that CEO chooses σ. • First-best strategy is associated with risk • E(PT) is increasing and concave in σif • E(PT) is weakly decreasing in σif How Important are Risk-Taking Incentives in Executive Compensation

11. Principal-agent models with effort and risk-taking incentives • Agent gathers information and makes project choice • Lambert (1986), Core & Qian (2002) • Agent‘s effort affects mean and variance of stock price • Feltham & Wu (2001), Lambert & Larcker (2004) • Continuous effort and volatility choice • Hirshleifer & Suh (1992), Flor, Frimor & Munk (2006) • Models in continuous time • Hellwig (2008) assumes risk-neutral agent How Important are Risk-Taking Incentives in Executive Compensation

12. The principal‘s problem • Assume that first-order approach holds, so that the incentive compatibility constraint can be written as: How Important are Risk-Taking Incentives in Executive Compensation

13. Calibration method • The full model cannot be calibrated to data, because P0(e,σ) and C(e) are unknown. • Solve a simpler problem (first stage of Grossman and Hart, 1983): Search for a new contract with a given shape that • provides the same utility to the agent, • generates the same effort incentives, • provides the same risk-taking incentives, and • is as cheap as possible. • If the model is correct, the new contract must be equal to the observed contract. How Important are Risk-Taking Incentives in Executive Compensation

14. Dataset Construction • Use CompuStat ExecuComp • Require 5 years of continuous history • Estimate wealth from previous years‘ income • Construct approximate option portfolios • Aggregate into “representative option“ with same value, same option delta and same option vega • We are left with 727 CEOs (for the year 2006). • Estimate volatility from daily CRSP returns How Important are Risk-Taking Incentives in Executive Compensation

15. Dataset: Descriptive Statistics Table 1 How Important are Risk-Taking Incentives in Executive Compensation

16. Optimal Contracts with Risk-Taking Incentives Table 3 How Important are Risk-Taking Incentives in Executive Compensation

17. Optimal Contracts that Consist of Salary, Stock, and Options • Consider contracts that consist of base salary, stock and one option grant. • Principal minimizes contracting costs over • Base salary • Number of shares • Number of options • Option strike price How Important are Risk-Taking Incentives in Executive Compensation

18. Optimal Contracts that Consist of Salary, Stock, and Options Table 6 How Important are Risk-Taking Incentives in Executive Compensation

19. In-the-money options and the U.S. tax system • IRC 409A: Executives must pay a 20% penalty tax on the intrinsic value of the option when it becomes exercisable. • Neglect other rules like IRC 162(m). • Repeat analysis with this tax penalty • Observed contract is optimal for 76% to 93% of all CEOs (depending on assumptions) • US tax system prohibits in-the-money options. How Important are Risk-Taking Incentives in Executive Compensation

20. Robustness test: Loss-Aversion Utility Function • Dittmann, Maug, Spalt (2010) showed that if CEOs are loss-averse, the principal agent model is able to explain current compensation practices. How Important are Risk-Taking Incentives in Executive Compensation

21. Optimal Contracts with Loss-Aversion How Important are Risk-Taking Incentives in Executive Compensation

22. Loss Aversion with Risk-Taking Incentives How Important are Risk-Taking Incentives in Executive Compensation

23. Conclusions • Optimal compensation structure from a principal-agent model where the agent chooses effort and firm-volatility • Model performs much better than a model w/o risk-taking incentives. • Small savings (10.4% vs. 54% w/o risk-taking incentives) • Small distance from observed contract (8% vs. 28.8% w/o risk-taking incentives) • Optimal contract is convex over some regions • Risk-taking incentives are not a issue in LAmodels, but the RTI explanation is less susceptive to parameter choices. • Risk-taking incentives are a major objective in executive compensation practice. How Important are Risk-Taking Incentives in Executive Compensation