CEO compensation, CEO attributes and corporate risk taking evidence from US listed corporations

Abstract

Using simultaneous equation models (SEMs) in which executive compensation and risk taking are endogenous, we find that different attributes of chief executive officers (CEOs) have various impacts on the relationship between compensation and the risk taking. The authors find that equity-based compensation induces managers to undertake value enhancing and risky projects, whereas cash-based compensation has an inverse effect. Although equity-based compensation induces managers to undertake projects with high risks, only option-based compensation positively motivates managers to take risks, and stock-based compensation conversely mitigates this incentive. The authors also find that overconfident CEOs undertake value-added risky projects by any type of compensation, whether cash-, stock- or option-based. However, for CEOs who are not overconfident or who have limited overconfidence, only equity-based compensation, particularly option-based compensation, induce them to take risks. Additionally, we find that CEOs rewarded with a high ratio of cash-to-total compensation, similar to CEOs with a high ratio of inside-debt claims, are less risky. The other CEO attributes, such as age, tenure and dominance, are found to significantly influence the impact of compensation on risks. Results of this study have some important implications for the design of compensation packages by considering the executives’ attributes.