Society & Culture - Posted by Andy Henion-Michigan State on Wednesday, September 19, 2012 8:35 - 3 Comments 
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(1 votes, average: 5.00 out of 5) Loading ...Will CEOs control risk if compensation’s at stake?
CEOs are sometimes rewarded for taking excessive risks—a practice that helped fuel the recent recession but could be altered if companies are more strategic in how they compensate their chief executives. (Credit: Veet)
MICHIGAN STATE (US) — Companies should compensate chief executives for managing risk, not reward them for taking excessive risks, research suggests.
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The text of this article by Futurity is licensed under a Creative Commons Attribution-No Derivatives License.
Instead of issuing stock and stock options in predetermined quantities, boards of directors should vary a CEO’s equity-based compensation through a plan that fosters the amount of risk-taking the firm desires, says Robert Wiseman, a professor of management at Michigan State University.
The vast majority of chief executive officers of public companies receive stock and stock options, and often that equity pay makes up more than half of their total compensation. As the person in charge, a CEO makes the final decision on potentially risky ventures such as whether to acquire or merge with another company.
“I would argue that the CEO incentive structure encouraged the excessive risk-taking that played a strong role in the recession,” Wiseman says. “So managing risk preferences though compensation is something that should be on the agenda of any company’s board of directors.”
For the study, Wiseman and colleagues Geoffrey Martin of Melbourne Business School and Luis Gomez-Mejia of Texas A&M University examined CEO compensation and financial data for publicly traded manufacturing firms from 1996 to 2009.
When it came to CEOs’ equity pay, the study analyzed current wealth—or how much the stock and stock options would be worth if cashed out today—and prospective wealth, or how much more the equity would be worth at its expiration date, typically years down the road.
Chief executives who had three times as much prospective wealth as current wealth were more willing to take potentially destructive risks. Those with roughly the same amount of current wealth and prospective wealth were less inclined to take such risks, ostensibly because they feared losing the sizable amount they had earned, Wiseman says.
A useful benchmark for companies looking to encourage value-enhancing risk-taking is about 2 to 1—or about twice as much prospective wealth as current wealth, the researchers said. In other words, a CEO who has $20 million in prospective wealth and $10 million in current wealth will likely take risks aimed at growing the company sensibly.
The findings challenge the current mindset guiding most compensation plans—that stock options carry no risk for chief executives.
But Wiseman argues that CEOs do, in fact, consider stock options when calculating their personal wealth, particularly as the options grow in value. Thus, equity pay should be issued more strategically.
“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,” Wiseman says. “Simply imitating what every other company is doing—like issuing a predetermined number of stock options semi-annually or annually—may not necessarily be the right thing to do.”
The study will appear in a forthcoming issue of the Academy of Management Journal. A version also appears in the October issue of Harvard Business Review.
Source: Michigan State University
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3 Comments
jeh
A true hero to the Romanians, for his defence of their religion and culture against the Turks, the rest of the world will always revile Vlad Dracula Tepes, for his fetes of barbarism and inhuman brutality to both his enemies and kinsmen alike. As with the tale of ErzsebetBathory, care should be taken in what to and what not, to believe. Vlad had many enemies and, just as in politics today, the peoples of 15th Century Europe, were not above carrying out smear campaigns. However, there can be very little doubt of the atrocities carried out by this man and which made him the most feared ruler of all time. As his nickname “Tepes” would suggest, Vlad’s preferred method of punishment and justice, was Impalement.
Man’s ingenuity in creating ever increasing, shameful and agonising deaths for his fellow men is incredible but few can exceed the act of impalement for its sheer agony, shame and the untold of horror it brought with it. The act itself was simple enough when placed in the hands of a skilled executioner and it was perhaps, this simplicity, that made it so terrifying. Thought to have been first used in the ancient lands of the Babylonians, Vlad excelled at it and introduced it proper, to the rest of the world.
Remember the government encourages this kind of risky behavior too – by taxing capital gains at lower tax rates.