Moving Closer to the Action: Examining Compensation Design Effects on Strategic Risk

Organization Science, No. 19, pp. 548-566, July - August 2008

19 Pages Posted: 5 Dec 2008 Last revised: 2 Jan 2011

See all articles by Cynthia E. Devers

Cynthia E. Devers

Michigan State University - Eli Broad College of Business and Eli Broad Graduate School of Management

Gerry McNamara

Michigan State University - The Eli Broad College of Business and The Eli Broad Graduate School of Management

Robert M. Wiseman

Michigan State University - Department of Management

Mathias Arrfelt

affiliation not provided to SSRN

Date Written: December 30, 2010

Abstract

We examine the influence of CEO equity-based compensation on the strategic risk taking by the firm. Building off of the Behavioral Agency Model, Agency Theory, and Prospect Theory, we develop arguments about when equity-based compensation elements will increase and when they will decrease executive risk propensity and, in turn, strategic risk taking. Incorporating a behavioral perspective into our models of incentive alignment provides us with new and potentially more accurate predictions about how individual elements of CEO pay will influence risk selection, as well as how equity compensation interacts with cash compensation and with other factors to influence risk preferences. In general, this study provides evidence that CEO equity-based compensation significantly influences strategic risk, but that this influence is more nuanced and complex than conventional treatments of executive compensation assume. In particular, we find that different forms of equity-based pay exhibit dissimilar influences on strategic risk and that their influence changes as their value and vesting status change. Second, we find that cash-based forms of pay moderate the incentive properties of equity-based pay, indicating that cash-based pay may affect how executives perceive risks associated with equity pay. Finally, we find that stock price volatility and board actions each also moderate the incentive effects of equity-based pay. In sum, our results argue for increased recognition of a behavioral perspective on executive compensation and greater precision in how we measure and model the incentive alignment properties of CEO compensation.

Keywords: Incentive Alignment, CEO Compensation, Corporate Governance, Strategic Risk

Suggested Citation

Devers, Cynthia E. and McNamara, Gerry and Wiseman, Robert M. and Arrfelt, Mathias, Moving Closer to the Action: Examining Compensation Design Effects on Strategic Risk (December 30, 2010). Organization Science, No. 19, pp. 548-566, July - August 2008, Available at SSRN: https://ssrn.com/abstract=1310464

Cynthia E. Devers (Contact Author)

Michigan State University - Eli Broad College of Business and Eli Broad Graduate School of Management ( email )

Agriculture Hall
East Lansing, MI 48824-1122
United States

Gerry McNamara

Michigan State University - The Eli Broad College of Business and The Eli Broad Graduate School of Management ( email )

East Lansing, MI 48824-1121
United States

Robert M. Wiseman

Michigan State University - Department of Management ( email )

North Business Complex
East Lansing, MI 48824-1122
United States
517-432-3508 (Phone)

Mathias Arrfelt

affiliation not provided to SSRN ( email )

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