If a company wants its CEO to play it safe, it should consider restructuring his or her compensation package.
A study co-authored by Michigan State University professor Robert Wiseman contends that rather than issuing stocksand stock options in predetermined quantities, boards of directors should vary a CEO's equity-based compensation through a plan based on the amount of risk-taking each company desires.
"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 through compensation is something that should be on the agenda of any company's board of directors."
For the study, researchers examined CEO compensation and financial data for publicly traded manufacturing firms from 1996 to 2009. The study analyzed current wealth, which is how much a stock or stock options would be worth if cashed out today, as well as prospective wealth, which is how much more the equity would be worth at its expiration date, typically years down the road.
The research found that company leaders who had three times as much prospective wealth as current wealth were more willing to take potentially destructive risks. At the same time, those with an equal amount of current wealth and prospective wealth were less inclined to take such risks out of fear of losing the sizable amount of wealth they had amassed.
The researchers found that the benchmark for companies looking to encourage value-enhancing risk-taking is having a CEO who has twice as much prospective wealth as current wealth. Those CEOs will likely take risks aimed at growing the company sensibly, the study's authors concluded.
Wiseman said findings challenge the current mindset that stock options carry no risk for chief executives.
"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," he said. "Simply imitating what every other company is doing – like issuing a predetermined number of stock options semiannually or annually – may not necessarily be the right thing to do."
The study, also co-authored by Geoffrey Martin of the Melbourne Business School and Luis Gomez-Mejia from Texas A&M University, will appear in an upcoming issue of the Academy of Management Journal.