The influence of CEO risk tolerance on initial pay packages

Abstract

Research Summary Based on agency theory, CEOs with greater risk aversion should be given greater incentive‐based compensation to motivate risk taking. We explore whether new CEOs receive initial pay packages that follow this recommendation, or instead receive pay packages that mirror their risk preferences. Rather than finding support for the agency theory perspective, we find that new CEOs are compensated in the way that reinforces their existing risk preferences. Specifically, using a CEO's political orientation to capture relative risk tolerance, we find that conservative‐leaning CEOs receive relatively less performance‐based pay than their liberal‐leaning counterparts. Supplemental analyses suggest this occurs through both a matching and tailoring process, whereby boards offer similar pay packages from CEO‐to‐CEO, but modify them based on differences in risk tolerances. Managerial Summary When designing a new CEO's pay contract, what proportion of the total compensation should be guaranteed versus performance based? To encourage risk taking, most researchers suggest that CEOs with greater risk aversion should have a pay mix that is more heavily weighted toward performance‐based pay. We find that the opposite occurs; new CEOs who are more risk averse tend to receive relatively less performance‐based pay than new CEOs who are more risk tolerant. This appears to occur because CEOs are attracted to firms that offered the prior CEO a pay package that appeals to the new CEO's risk tolerance. Our results also suggest that risk‐seeking CEOs' strategic actions are more strongly influenced by performance‐based pay, while more risk‐averse CEOs seem relatively unaffected by pay mix.

The Curse of Extremes: Generalist Career Experience and CEO Initial Compensation

“…Our theory and results stress that the notions of generalism and specialization should be considered together, as CEOs with balanced careers (i.e., those who maintain a relative balance between generalism and specialization) are those who are most valued by the market for executive labor and thus receive higher initial compensation. Broadly speaking, our results have implications for the 'resource-based' perspective of CEO human capital (Campbell, Coff, & Kryscynski, 2012;Carpenter et al, 2001;Finkelstein et al, 2009;Mackey, Molloy, & Morris, 2014), as well as for the emerging literature on CEO initial pay (Bragaw & Misangyi, 2017;Chen, 2015;Graffin et al, 2020). Prior studies have regarded broad-general managerial skills as a relatively scarce human capital resource (Mackey et al, 2014), arguing that CEOs with broad-general experience from various firms and industries are those who receive higher initial remuneration returns as a result of their prior career investments (Custodio et al, 2013).…”

“…Whereas scholars have separately investigated the individual (Harris & Helfat, 1997), organizational (Chen, 2015), and industry (Finkelstein & Boyd, 1998) determinants of CEO pay, the conjoint impact of multilevel factors has rarely been explored (for exemptions see: Graffin et al, 2020;van Essen et al, 2012). Contributing to this emerging area, our study underscores the complex and multilevel nature of the relationship between CEO career experience and initial compensation.…”

“…[CEO] initial compensation negotiation is relatively immune from the entrenchment of CEO power." Focusing on CEO total initial compensation therefore allows us to adequately examine the hypothesized relationships in a context where CEO pay is mostly determined by human capital considerations, rather than by managerial power (Chen, 2015;Graffin et al, 2020).…”

“…Arguably, a CEO with moderate levels of generalist career experience may also exhibit an overall higher likelihood of appointment to CEO positions across firms facing different conditions, and may therefore receive a larger number of job offers (Merluzzi & Phillips, 2016 Relatedly, the use of archival data does not allow us to observe the risk preferences of CEOs, as well as the risk considerations of firms, in order to reveal how deeply-held behavioral factors may have affected the compensation-negotiation process. In a recent study, Graffin et al, (2020) found that a key proxy for CEO valuesi.e., political ideologyimpacts CEOs' inherent risk preferences regarding the structure of their compensation packages. Future studies can build on the approach of Graffin et al and integrate elements from recent research on CEO big-five personality traits (Harrison, Thurgood, Boivie, & Pfarrer, 2019), to examine how risk perceptions of the CEO and the board of directors affect CEO initial compensation.…”

Metacritiques of Upper Echelons Theory: Verdicts and Recommendations for Future Research

“…UET stands to play an important role in offering insight into how executive orientation shapes leaders’ actions in these situations—personally and organizationally—as well as what consequences their decisions have for both firm performance and outcomes outside the firm (e.g., public opinion, government policies, analyst response; Hambrick & Wowak, in press; Wowak et al, 2016). Thus, these topics have begun to garner greater research attention (e.g., Christensen, Dhaliwal, Boivie, & Graffin, 2015; Graffin, Hubbard, Christensen; & Lee, in press; Gupta & Wowak, 2017). As an example, Chin, Hambrick, and Treviño (2013) used 10 years’ worth of publicly available records on CEO political donations to illustrate how CEOs’ political ideologies shape firms’ approaches to CSR activities.…”