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Samuel R. Gray and Albert A. Cannella, Jr. The Role of Risk in Executive Compensation

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Journal of Management 1997. Vol. 23, No. 4. 517-540

The Role of Risk in Executive Compensation

Samuel R. Gray University of Richmond

Albert A. Cannella, Jr. Texas A&M University

The present study was designed to investigate the role of risk in executive compensation. We argue that compensation arrangements may be used to mitigate agency problems by encouraging risk taking behavior and providing incentives for optimizing long-term petfor- mance. We examine total compensation, compensation risk, and compensation time horizon. Consistent with our theory, the evidence indicates that these dimensions vary with the financial and strategic context of the firm and with the risk-taking propensity of the CEO.

Executive compensation has been a topic of great interest among scholars of management, finance, and accounting. Much of the research has focused on the parallel issues of level of compensation (how much executives are paid) and the observed association (or lack thereof) between pay level and organizational performance. The emphasis on pay level is understandable when one considers the large absolute size of the salaries many Chief Executive Officers (CEOs) receive, especially as compared to those of line workers or organization scholars. The emphasis on the association between pay and performance arises from the dominance of agency theory as an explanation of the executive role (Fama, 1980; Fama & Jensen, 1983; Eisenhardt, 1989; Walsh & Seward, 1990) coupled with the widespread tendency, among people of Western cultures, to attribute organizational outcomes to leadership (Meindl, Ehrlich & Dukerich, 1985; Chen & Meindl, 199 1). The normative prescription of agency theory-that compensation arrangements should link the level of executive pay closely to firm performance- seems very appealing.

Perhaps the most conspicuous conclusion from the above research is that the agency theory prescription that pay should be closely tied to organizational performance’ has fared poorly in empirical studies of executive compensation (Baker, Jensen & Murphy, 1988). While several authors have provided evidence that boards of directors can have an important influence on executive compensation

Direct all correspondence to Samuel R. Gray, E. Claibome Robins School of Business, University of Richmond. Richmond, VA 23173 <[email protected]>.

Copyright 0 1997 by JAI Press Inc. 0149-2063

517



518 SAMUEL R. GRAY AND ALBERT A. CANNELLA JR.

(Gomez-Mejia, Tosi & Hit&in, 1987; Tosi & Gomez-Mejia, 1989; Zajac, 1990; Boyd, 1994), the most consistent conclusion in the literature is that firm size accounts for the greatest proportion of variance in executive compensation level and that firm performance accounts for very little (Finkelstein & Hambrick, 1988). Further, while firm size is usually significantly associated with compensation, it typically explains only a small proportion of the variance, leading to inconsistent conclusions across studies. This observed lack of association between executive pay and firm performance is a source of never-ending discussion in the popular press. Among news reporters, a growing number characterize compensation prac- tices with terms like “madness” (Loomis, 1982) or “wacky” (Crystal, 1988).

While the level of compensation and the association between firm performance and compensation level have been widely investigated, much less attention has been paid to the manner in which executives are compensated (Gerhart & Milkovich, 1990), that is, the mix of fixed and incentive components. This over- sight is somewhat surprising given the large variance in compensation arrangements observed across firms (Murphy, 1985) and the fact that most authors conceptualize executive compensation policies as key incentive levers that are central to corporate governance (Walsh & Seward, 1990; Baker et al. 1988; Finkelstein & Hambrick, 1989; Lambert, Larcker & Weigelt, 1991).

Our study differs from previous work on executive compensation in that we examine the role of risk in the compensation arrangements that we observe. Like Sitkin and Pablo (1992) we define risk as the extent to which there is uncertainty about outcomes. Our theoretical development concludes that executives and shareholders confront very different risks, and that these risk profiles cannot always be aligned in the context of pay packages that closely link pay to performance. Shareholders manage risk through portfolio diversification. Executives, however, do not have this option. As a result, we find that several compensation arrangements, while not necessarily linking pay to performance, do serve to align the risk preferences of managers and shareholders.

There are at least two problems with applying the prescription of linking pay closely to performance in large, public corporations. First, executives cannot bear the full wealth effects of their decisions because most simply do not have enough wealth. Even a 2% ownership of a Fortune 100 company could involve an investment of more than $1 billion. Second, if a person’s wealth is limited to a single investment, one can expect that the person will behave in a risk-averse manner with respect to that investment. Therefore, one great benefit of separating ownership and control-diversified risk-bearing-is not available to executives. Their capital is largely human capital, and may be of little value outside the specific organization in which they were promoted (Coffee, 1988; Castanias & Helfat, 1991). Further, when firm performance is poor, executives risk the loss of their jobs and much of their earnings potential (Coughlan & Schmidt, 1985; Gilson, 1989; Cannella, Fraser & Lee, 1995). Given this backdrop, it is not always possi- ble to closely align pay and performance, while still expecting executives to invest firm resources in a risk-neutral manner. Our central assertion is that the conflicts of interests between risk-averse executives and risk-neutral shareholders may be

JOURNAL OF MANAGEMENT, VOL. 23, NO. 4, 1997



RISK AND EXECUTIVE COMPENSATION 519

partially resolved through a mix of compensation components-some fixed, others performance-contingent; some short-term, others long-term.

Agency Theory and Executive Risk Bearing

Our review of the agency literature suggests that there are three dimensions of executive compensation that are relevant in risk sharing between principals and agents. These three dimensions are total compensation, compensation risk, and compensation time horizon. Each of these dimensions is considered separately in the discussion that follows.

Total Compensation

Agency theory deals with the conflicts of interest between managers and stockholders (Jensen & Meckling, 1976; Fama, 1980; Fama & Jensen, 1983). Managers are the hired agents of stockholders (the principals) and may have incentives to behave in ways which do not maximize firm wealth. The conflicts revolve around two primary elements. First, managers may have incentives to maximize their utility through the consumption of perquisites (Lambert & Larcker, 1985), growth in the size of the firm (Baumol, 1958), or by pursuing strategies that help them maintain their positions at shareholder expense (Merck, Shleifer & Vishny, 1989). Second, and more important to the present research, managers may differ greatly from shareholders in their attitudes toward risk (Coffee, 1988). Shareholders can, at low cost, diversify their investments over many firms and thereby lower the risk from any one investment. In fact, this ownership of a diversified portfolio renders shareholders risk-neutral with respect to any particular investment (Sharpe, 1964). Executives, however, cannot diversify their risk because of their close association with the firm. An executive can hold only a single job, and is unlikely to be risk-neutral with respect to that job. Further, executives are aware that their own competence is likely to be assessed in reference to the performance of their organizations (Fama, 1980; Meindl, Ehrlich & Dukerich, 1985). The negative implications of poor organizational performance on executive careers have been well developed in the literature, and include dismissal (Fredrickson, Hambrick & Baumrin, 1988; Mizrichi, 1983), sharp declines in income (Fama, 1980), failure to find subsequent employment (Gilson, 1990; Cannella, Fraser & Lee, 1995), and ostracization from one’s peers (Sutton & Callahan, 1987).

Walsh and Seward (1990) and Hambrick and Snow (1989) note that executive compensation is one of the mechanisms that boards of directors can use to reduce agency costs. The options considered by directors include decisions about pay level as well as pay mix, with pay mix referring to the proportions of fixed and performance contingent components in executive compensation packages. The fixed components help protect executives from factors beyond their control, such as poor exposte outcomes from strategies that, a priori, appeared promising. While in some instances, such as when pursuing extremely risky strategies, a fixed salary with no incentive components may be acceptable, such arrangements




520 SAMUEL R. GRAY AND ALBERT A. CANNELLA JR

provide few direct incentives for executives to exert effort toward shareholder goals (Shavell, 1979).

Basing pay entirely on firm outcomes increases the risk borne by the executive (Shavell, 1979; Coffee, 1988; Sloan, 1993; Hambrick & Snow, 1989). The necessity of designing compensation contracts that balance incentives with efficient risk sharing was noted by Jensen and Murphy (1990) and represents an area in which more research is warranted. There are several reasons to believe that the risks associated with an organization’s strategy may be an important consideration in establishing the level of executive compensation. First, as noted above, executives know that organizational outcomes, both good and bad, are likely to be attributed to them. When performance is poor, shareholders may call for the dismissal of the executive cadre (Fama, 1980; Fredrickson, Hambrick & Baumrin, 1988; Hambrick & Snow, 1989). Directors, concerned for their own reputations, may be inclined to dismiss executives to provide visible evidence that they (the directors) are doing their jobs (Gamson & Scotch, 1964; Lublin, 1994). Once dismissed, executives lose any firm-specific human capital that they have accumulated, and are unlikely to find equivalent employment elsewhere (Castanias & Helfat, 1991; Coughlan & Schmidt, 1985; Cannella, Frasier & Lee, 1995). Thus, even when compensation is fixed (not performance contingent), there may be very real and sizable costs that executives are forced to bear when performance outcomes are poor. These costs incline executives to minimize the risks associated with their strategies, thus leading to decisions that are not aligned with the interests of a fully diversified (and hence, risk-neutral) shareholder.

One contractual mechanism for encouraging risk-taking behavior by executives is the payment of a risk premium (Shavell, 1979). When firms are character- ized by high risk, raising the level of total compensation will reduce the negative effects of this risk on the executives in charge. Thus, we expect to observe higher levels of total compensation among higher risk firms.

Hl: There will be a positive association between total CEO compensation andfirm risk, all else equal.

Compensation arrangements vary in the extent to which executives bear risk regarding the level of compensation that they are paid year to year. At one extreme, executives with only fixed salaries bear no compensation risk. At the other extreme, executives with only performance contingent compensation bear large risks with respect to the level of compensation. We refer to the extent to which an executive’s total compensation depends upon ex poste factors like firm profitability or stock price as compensation risk. Because executives tend to be risk-averse, they may demand higher overall compensation in exchange for riskier compensation arrangements. Viewed in this way, a higher pay level represents a risk premium that may enable the firm to attract and retain highly qualified executives. A strong positive association between compensation risk and pay level may reflect an institutional arrangement that prevents a “lemons effect” (Akerlof, 1970) from occurring. The lemons argument, extended to executives, begins with the assumption that risk-averse executives prefer employment with less risky





compensation arrangements. Higher quality managers are likely to have more opportunities for outside employment than are lower quality managers. If high risk compensation contracts are imposed on executives with no corresponding increase in pay level, higher quality executives may seek opportunities elsewhere. Carried to the extreme, this reasoning implies that over the long term firms with high risk compensation arrangements may find themselves with a disproportion- ate number of lower quality managers, i.e., the “lemons.”

Fama and Jensen (1983) argue that outside employment opportunities for executives will be importantly influenced by the performance of their firms. Because increased firm risk means increased variability in performance outcomes, executives employed by high-risk firms may require a risk premium, as poor performance (regardless of cause) will be attributed to them. Cannella, Fraser, and Lee (1995) investigated the association between culpability for bankruptcy and post-failure re-employment among bank executives. They concluded that executives with little culpability for bank failure fared far better than other executives of failed banks in securing re-employment following the failure, but still bore a cost relative to executives of banks that did not experience failure. Even high quality managers suffered when their firms performed poorly. For this reason, high levels of executive pay may be used as side payments to executives for accepting employment at risky firms. The arrangement benefits stockholders because it rein- forces the risk-taking behavior that stockholders desire and helps the firm to retain top quality managers, even in risky settings.

H2: There will be a positive association between total compensation and compensation risk, all else equal.

Compensation Risk

Compensation risk, as noted earlier, is the extent to which an executive’s compensation depends upon ex poste outcomes. Our discussion of agency theory suggests that there may be an optimal level of risk sharing between principals and agents, and that compensation arrangements can be used to bring about risk sharing. Placing some of the risk associated with firm outcomes on the executive is advantageous to shareholders because it provides incentives for executives to engage in strategies that are consistent with shareholders’ preferences. On the other hand, if executives are subjected to too much risk, their decision making is likely to become too risk-averse (Lewellen, Loderer, & Martin, 1987; Coffee, 1988). Compensation contracts, therefore, should balance the advantages of incentives with the disadvantages of excessive risk bearing by executives.

Firm risk affects the personal risk of the executive when compensation is contingent upon firm-level outcomes such as profitability or stock price movements, rather than executive-level inputs such as effort or task performance (Gerhart & Milkovich, 1990; Sloan, 1993). Pay based on outcomes always represents a source of risk to the executive, and that risk increases as the efforts and activities of the executives become dissociated from firm-level performance. Compensation risk reflects the extent to which personal and non-diversifiable risk





is imposed upon the executive through the compensation arrangement (Lambert & Larcker, 1985).

One way in which directors can encourage executive risk-taking behavior is to insure the executive against personal losses associated with very negative outcomes. For example, firms that are facing financial difficulties may have to pay large signing bonuses to attract managerial talent. These bonuses have the effect of eliminating or reducing the personal risk facing the executive, because some level of their personal wealth is assured regardless of the performance outcome (Beatty & Zajac, 1994). Perhaps the largest personal risk facing the executive involves the possibility of his or her dismissal in the event of poor firm performance (Gilson, 1989; Fredrickson et al., 1988) or a takeover by another firm (Manne, 1965). As Walkling and Long (1984) and Coffee (1988) have noted, the conflicts of interest between managers and shareholders are very intense during takeover battles. For executives, there is the unpleasant prospect of losing independent control of the firm, at a minimum, or their jobs (Walsh, 1988; 1989; Hambrick & Cannella, 1993). Shareholders, on the other hand, want the takeover to be consummated, as they tend to reap large gains from these transactions (Jensen & Ruback, 1983; Bradley, Desai & Kim, 1983).

It has been noted that golden parachutes may help to align the incentives of executives and shareholders during takeover negotiations (Jensen, 1984; 1988; Lambert & Larcker, 1985; Singh & Harianto, 1989). Golden parachutes insure executives against takeover-related losses by compensating them with an average of three years of income if they subsequently lose their jobs (Singh & Harianto, 1989). Lambert and Larcker (1985) investigated this rationale for golden parachutes by examining the stock market reaction to the adoption of golden parachute contracts and concluded that incentive alignment was the primary motive behind them. While some authors view golden parachutes as simply devices for transfer- ring shareholder wealth to managers (Wade, O’Reilly & Chandratat, 1990), our theory suggests an incentive alignment motive.

Golden parachutes are more likely among firms which have been the subject of takeover interest (Singh & Harianto, 1989; Wade, O’Reilly & Chandratat, 1990). Further, takeovers are more likely when both firm and industry performance are poor (Manne, 1965; Jensen & Meckling, 1976; Merck, Shleifer & Vishny, 1989). We believe that the level of risk associated with the firm is also likely to be positively associated with takeover bid likelihood. Gort (1969) noted that investor valuation discrepancies (one measure of firm risk) increase the likelihood of takeover bids, as discrepancies increase the likelihood that some bidders will value firms high enough to make purchase offers. Following this reasoning, high risk firms are more likely to be takeover targets than low risk firms. While directors may promise to support executives if performance turns out poorly, these promises are contingent on the firm surviving as a stand-alone entity. Thus, in high risk contexts, golden parachutes may serve as efficient contract mechanisms in that executives are insured against some financial losses if a disappointing period of earnings leads to a takeover. This insurance may serve the interests of both executives and shareholders. It is suggested, therefore, that high risk firms will be more likely to implement golden parachute arrangements than low risk firms.





H3: There will be a positive association between firm risk and the likelihood that a golden parachute will be adopted, all else equal.

One of the most commonly applied prescriptions of agency theory is that executive pay should be based, at least in part, on firm-level performance outcomes. Viewed from the perspective of management theory, however, contingent pay will be more effective in motivating human behavior when outcomes can be controlled or influenced by the person involved (Lawler, 1971). Linking pay to factors beyond the control of management is not likely to positively affect the motivation of the executive.

Executives may feel they have little control over stock prices when their firm faces a high level of systematic risk. The systematic risk component (Beta) of financial risk refers to covariation of firm stock returns with the returns of the overall market for risky assets (Sharpe, 1964). In high Beta firms, stock price movements are strongly associated with economy-wide influences such as economic cycles, interest rates, and government policies. Management exerts little or no control on these macroeconomic variables. From a management theory perspective, high levels of compensation risk would be suboptimal in such firms.

H4: There will be a negative association between compensation risk and systematic risk, all else equal.

Another scenario in which high levels of compensation risk may be undesir- able is the case in which the CEO has a large equity stake in the firm. By having a large proportion of his or her individual wealth invested in the firm, the executive is bearing high levels of personal risk, even in the absence of any additional compensation risk (McEachem, 1975). Since the definition of compensation in this paper excludes wealth gains due to personal investment in the firm, compensation risk is independent of the executive’s personal investments.2

The theory presented in this paper suggests that an important function of compensation mix is to facilitate risk sharing between principal and agent. Equity holdings by the executive may serve as a viable substitute for compensation incentives (McEachem, 1975; Jensen & Meckling, 1976). Executives with large equity holdings in the firm may need little or no additional incentives from the compensation contract. Thus, the association between compensation risk and the CEO’s equity holdings is expected to be negative.

H5: There will be a negative association between compensation risk and CEO stock ownership, all else equal.

Compensation Time Horizon

Compensation time horizon is defined as the extent to which the total compensation package provides financial rewards to the executive based on long-term performance outcomes. The agency literature suggests that compensation contracts can be used to encourage and reward long-term decision making (Walsh & Seward, 1990). A focus on the long run benefits the organization and its shareholders





because it encourages the building of resources that may serve as sources of future competitive advantage. The effects of compensation mix on decision time horizon has been noted in the normative literature (Hayes & Abernathy, 1980). Miller and Bromiley (1990) developed a taxonomy of firm risk which included the concept of strategic risk. Strategic risk deals with the level of investment in physical capital and in the intangible resources that accrue from research and development and advertising. Compensation time horizon, following the theme of this research, is expected to vary according to the strategic risk of the firm.

As an example, consider the case of a CEO who receives only salary and a yearly bonus based on current year accounting returns. The CEO can maximize his or her total compensation by taking actions that increase net income in the present accounting period. One way to accomplish a short-term increase in accounting returns is to reduce or eliminate expenditures for research and development, employee development programs, and advertising. Since each of these three expenditures is expensed against current period revenues, the result is an increase in reported net income and a corresponding increase in compensation. The reduction, however, may lessen the firm’s ability to compete effectively in the future. An executive whose pay is heavily tied to short-term accounting results may therefore have incentives to reduce the firm’s long-run effectiveness (Hill, Hitt & Ho&&son, 1992).

A CEO who receives compensation based on a longer time horizon has incentives to behave differently. Consider an executive who receives part of her compensation based on multipe~~ firm performance. An example of such an a~angement would be one which bases each year’s bonus on the past three years’ performance. The executive can then maximize his or her total compensation by engaging in strategies that build long run profitability for the firm by maintaining high levels of investment in research and development, capital expenditures, and advertising.

H6: There will be a negative association between compensation time horizon and strategic risk, all else equal.

Zajac (1992), and Hambrick and Snow (1989) have argued that the personal traits of the executives involved must be considered in fo~ulating effective compensation a~angements. There are several reasons why this ~gument is attractive to the present research. Agency theory typically assumes risk aversion on the part of the agent. New insights emerge, however, when risk aversion is perceived to be a variable, rather than a fixed property of executives. Viewed in this way, characteristics of the executive that may influence risk aversion are theoretically important to compensation arrangements. In addition, executives are able to exert some (perhaps considerable) influence over their own compensation terms (Finkelstein & Hambrick, 1989). Thus, the executive’s risk aversion may be reflected in the compensation scheme.

The executive’s age may influence his or her decision making time horizon (Taylor, 1975; Hambrick & Snow, 1989; Lambert, Larcker & Weigelt, 1991). Younger executives may willingly take a long-term approach because they recog- nize the potential future personal rewards. In other words, additional incentives

JOURNAL OF MANAGEMENT. VOL. 23, NO. 4, 1997




for long-term risk taking behavior may be redundant for the young CEO. Older executives, on the other hand, may derive utility from the stability of firm returns and favor a shorter term decision horizon. In the case of older executives, additional incentives from the compensation arrangement may be needed to encourage long-term perspectives. One way this can be accomplished is to tie the executive’s compensation to future outcomes, i.e., to increase the time horizon of the pay contract.

H7: There will be a positive association between compensation time horizon and CEO age, all else equal.

Another mechanism for generating long-term incentives is equity ownership by the executive. The CEO’s personal equity stake in the firm provides incentives for long-term maximization of firm wealth because the CEO’s wealth is also affected (McEachem, 1975; Jensen & Meckhng, 1976; Fama, 1980). As a result, high levels of CEO stock ownership may mitigate the need for additional time horizon elements in the pay mix.

H8: There will be a positive association beseech ~ompensatian time horizon and CEO stock ownership, all else equal.

Method

Sample

The sampling frame consisted of the 1,000 largest publicly traded, nonregulated firms listed on the New York Stock Exchange, the American Stock Exchange, or the NASDAQ Exchange. The sampling frame was limited to firms in nonregulated industries whose stocks were continuously traded for at least a five-year period between January 1, 1980 and December 31, 1989. Regulated industries (banking and public utilities) were exciuded because regulation restricts executive discretion, leading us to expect that incentive compensation arrangements may differ substantially between regulated and unregulated firms (Hambrick & Finkelstein, 1987). There are other factors, of course, that may constrain executive discretion, but we feel that legal constraints faced by regulated industries are particularly salient to this research. As regulated companies, there is less need for incentive compensation schemes, as much of the firm’s strategy and performance is determined by public policy.

From the sampling frame described above, a simple random sample of 100 firms was generated using a random number table. Ideally, this would have yielded 1,000 firm-years (100 firms each observed for the years 1980-1989). Missing data, mostly from proxy statements, reduced the usable number of observations to 7.50 firm-years. The final dataset includes info~ation on 100 firms and 162 chief executives.

All dollar amounts are stated in 1979 dollars. This adjustment is necessary because the data cover a lo-year time span. The adjustment involves dividing each dollar measure by the GNP deflator for the year represented. The GNP defla-

JOURNAL OF MANAGEMENT, VOL. 23, NO. 4, I997




tors were gathered from the Statistical Abstract of the United States (U. S. Bureau of the Census, 1991).

Measures of Executive Compensation

Total compensation is measured as the net present value of all pecuniary benefits, including those to be received in future periods, which accrue to the executive in the current period. Included are salary, current year bonus, miscellaneous cash payments, savings plans, long-term performance plans, stock options, stock grants, deferred compensation, below-market-rate loans, and accruals to pension plans.

The remainder of this section presents the details of the methods employed for the valuation of the noncash elements of executive compensation mix. Most of these valuation techniques are based on Antle and Smith’s (1985) methodology, which converts each item of compensation into its current income equivalent (CIE) by assigning compensation to the year in which it accrues and discounting its value to a net present value in that accrual year using an appropriate discount rate. This method allows for the evaluation of the current year wealth effects of the executive’s entire compensation package.

Cash Compensation and Bonuses. Current year cash compensation includes salary, short-term bonuses, and miscellaneous forms of cash income. The value reported in the proxy statements and the CIE are identical. Since payments are in cash, no discounting is necessary.

Savings Plans. Savings plan contributions are the firm’s portion of the addition to the executive’s savings plan with the firm. These amounts are not discounted, as they represent current year compensation.

Long-Term Performance Plans. Long-term performance plans award compensation based on performance over a multiyear period. The method used to allocate this form of compensation is the one recommended by Antle and Smith (1985). The actual payments received are allocated in equal shares to each of the years in the period in which performance is evaluated, with each year’s portion discounted by the risk-free rate.

Stock Options. The valuation of stock options presents a formidable task for researchers. Considerable controversy surrounds each of the methods of evaluat- ing this important source of executive compensation. This controversy is moti- vated by the observation that executive stock options differ from stock options owned by the general public since the former are not tradable in any market.

In order to partially circumvent this evaluation problem, we used a modified form of the Black-Scholes option pricing method, which takes into account the payment of dividends on the firms’ stock (Noreen & Wolfson, 1981). Details of this valuation method are provided in an appendix available from the first author upon request.

Briefly, in order to value stock options, it is first necessary to classify them according to grant period. Each grant of stock options represents a layer that must be valued separately and summed to determine the total value of outstanding options. Each layer of options is tracked through time in order to match exercised options with the relevant exercise price. The basic valuation procedure involves





the identification of ending inventories of each layer, each year, as well as the options exercised during the year. A value is then assigned to each layer of options with each of the valuation methods mentioned earlier. Once this is done, the change in wealth effects with each passing year is readily calculated as the difference between the annual valuations of the sum of all outstanding options plus the value of any options exercised during the year. For both option valuation methods, options exercised in the current year are valued at the number of shares exercised multiplied by the difference between current market price and exercise price. The valuation of outstanding options at the close of the prior year is then subtracted from the options exercised to prevent over counting.

Stock Grunts. Compensation in the form of outright stock grants and/or stock bonuses are valued as the product of the number of shares awarded and the stock price at the beginning of the fiscal year in which the shares are awarded. These are not discounted, as they represent current year compensation.

Deferred Compensation. Some executives have provisions in their employment contracts which allow them to defer a percentage of their current year salary until a later time period. This deferred compensation may or not be aggregated with current year salary in the proxy statement. Thus, the CIE of deferred compensation must be calculated and assigned to its accrual year in order to obtain an accurate measure of total compensation. Deferred compensation is not discounted, as the amounts reported are for current year deferrals and/or increases in accumulated deferred compensation.

Below-Market-Rate Loans. Executives are occasionally granted loans from their employers at below-market interest rates. Since the rates are more favorable than the executive could receive from a commercial lending institution, the executive enjoys an increase in his or her wealth when the loan is granted. The CIE of such loans is calculated as the face value of the loan minus the net present value to the firm of the future loan payments at the market interest rate, which we estimate as the prime rate plus two percentage points.

Accruals to Pension Plans. Changes in future pension benefits are considered as compensation received in the year in which the increase is awarded (Antle & Smith, 1985) rather than the year in which the cash is received. The CIE of changes in pension benefits is calculated as the net present value of an annuity which provides a lifetime annual income from the year of retirement equal to the awarded increase. The discount rate employed is the risk-free rate for the current year as reported in Salomon Brothers’ An Analytical Record of Yields and Yield Spreads.

Totul Compensation. Total compensation is defined as the sum of every component of compensation discussed above. Lewellen and Huntsman (1970) report that total compensation is a good proxy for cash compensation (salary and bonus) in their study of executive compensation. For our study, the correlation between total compensation and cash compensation (salary plus bonus) is .43. While significant, this correlation suggests that less than 20% of the variance in total compensation is explained by salary plus bonus.

Golden Parachutes. The existence of golden parachutes was recorded as a dummy variable taking on the value 1 if present, 0 otherwise.





Measures of Compensation Mix Variables

Compensation Risk. The measure of compensation risk is defined as the ratio of incentive compensation to total compensation in the year prior to the observation. This measure was chosen to capture the a priori uncertainty surrounding the total amount of compensation an executive could receive.

Compensation Time Horizon. The relative emphasis on the long-term component of executive compensation is measured as the proportion of current year compensation that is based on multiyear performance. This long-term component includes long-term performance plans, bonuses and grants that are awarded for performance over a period of more than one year, and stock options. The measure used to gauge the relative emphasis on the long-term component of compensation is the ratio of the long-term component to total compensation. Total compensation, as noted above, is the sum of all compensation elements in the pay mix.

Other Measures Used in the Research

Firm Risk. Firm risk is operationalized by the systematic risk (Beta) and unsystematic risk (Sigma), both derived from the Capital Asset Pricing Model, or CAPM (Lintner, 1965). In addition, we include income stream risk (the standard deviation of Return on Sales over the previous 3 years), research and development intensity (R&D expenditures/sales), advertising intensity (advertising expenditures/sales), and capital intensity (fixed assets/sales) (Miller & Bromiley, 1990).

Firm Size. Prior research has often concluded that executive compensation covaries with firm size (Finkelstein & Hambrick, 1989; O’Reilly, Main & Crystal, 1988) and thus size is included as a control variable. Firm size is measured by log of sales revenue.

Executive Characteristics. Included in the research design are the executive characteristics of age (measured in years) and CEO stockholdings (percent of shares outstanding owned by the CEO).

Firm Petiwmance. Jensen’s alpha was used as the measure of market performance. Jensen’s alpha represents the intercept term of the CAPM. Return on sales (net income/sales) was used as the accounting measure of performance.

Other Controls. Research suggests that level of compensation may depend on the titles held by the CEO (Finkelstein & Hambrick, 1988; Rechner & Dalton, 1991). We therefore included a dummy variable indicating CEO duality. That variable is coded 1 when the CEO is also Chairman of the Board, and 0 otherwise. CEO tenure is also included as a control variable, and is gauged in years.

Analyses

The data set represents a panel of observations representing 100 firms, each of which is observed each year between 1980 and 1989. This presents problems in analysis, because the observations are not independent, may exhibit different associations between independent and dependent variables across cross- sectional units, and may have dissimilar variances across cross-sectional units. In order to correct for these shortcomings, a panel data analysis was used. While we would like to pool the observations (treat each as an independent

JOURNAL OF MANAGEMENT. VOL. 23, NO. 3. 1997




observation), we are restricted in our ability to do so without making adjustments. Following procedures outlined in Greene (1990) and Hsiao (1986), we tested the data sets for the appropriateness of pooling, and made adjustments when necessary. We started by testing for fixed effects of year and firm (the two cross-sectional units), and making adjustments when necessary. We then tested for heteroscedascity across firms and years, and adjusted when necessary. In the resulting data sets, no autocorrelation was present. We caution the reader, however, that our methodology is a generalized least squares (GLS) one. For that reason, we can interpret coefficient signs and significance levels, but cannot make direct interpretations regarding the magnitude of regression coefficients because the datasets have been corrected for fixed effects and heteroscedascity. An appendix, available from the second author upon request, details the tests conducted and adjustments made.

To test the hypothesis about golden parachutes, a discrete-time event history method was used (Allison, 1984). Each firm was included in the data set each year, up to and including the year in which the firm adopted a golden parachute. Only 30 of the sample firms adopted a golden parachute during the sample period. Upon adoption, firms are dropped from subsequent years because they are no longer “at risk” of adoption in those years. Thus, the discrete-time event history analysis includes 628 observations (firm-years).

Results

The means and standard deviations of all compensation components are reported in Table 1. The largest single component in the average pay mix is salary (45.9%), followed closely by stock options (24.0%) and cash bonus (14.2%). The other pay components together represent only 15.9% of total compensation in the sample. Table 1 also indicates an important, but typically ignored, fact of executive compensation: it can be negative (and substantially so) when all elements are

Table 1. Descriptive Statistics for Each Component

of Executive Compensation (1979 Dollars).

Form of Compensation Mean Std Dev. Mininum Maximum % of Total

Cash Salary 3 10,345 168,493 58,479 1,266,861 46.0%

Cash Bonus 95,856 224,897 0 2,901,661 14.2%

Deferred Compensation 7,017 29,437 0 275,000 1.0%

Stock Options 161,334 1,250,827 -.5,883,368 9,823,427 23.9%

Long-Term Plan 24,332 57.917 0 469,425 3.6%

Pension Accruals 30,650 79.087 -241,301 554,697 4.5%

Stock Bonus 26,718 124,701 0 1,310,917 4.0%

Miscellaneous 18,688 43,53 1 0 365,247 2.8%

Total Compensation 674,942 1,358,787 -5,036,OlO 13,152,572 100%

JOURNAL OF MANAGEMENT. VOL. 23. NO. 4, 1997



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considered together. When a CEO holds a large portfolio of options and the firm’s stock falls dramatically during the year, the wealth decline faced by the executive can be sizeable. One would not come to this conclusion, however, by reading reports of CEO compensation in the popular press.

The means, standard deviations, and intercorrelations among the variables used in the analysis are presented in Table 2. These variables, as defined earlier, are Total Compensation, Compensation Risk, Compensation Time Horizon, Jensen’s Alpha, Return on Sales (ROS), Beta (systematic risk), Sigma (unsystematic risk), Income Stream Risk (standard deviation in ROS), CEO Ownership%, CEO Age, CEO Tenure, and Firm Size (log of sales).

Our analysis began with a regression of total compensation on firm risk (Beta, Sigma, and Income Stream Risk), Compensation Risk, Return on Sales, Jensen’s Alpha, Board Chairman, CEO Tenure, and Firm Size. The data set was corrected for fixed effects across firm, and heteroscedascity across both year and firm. The Durbin-Watson statistic in this adjusted data set was 2.00, suggesting that autocorrelation was not a problem.

Hypothesis 1, which predicted that there would be a positive association between total compensation and firm risk, is tested in Table 3 by the sign and

Table 3. GLS Regression Analysis of Total Compensation Dependent Variable is Total Compensation

Variable

Intercept

Firm Risk

Beta (Systematic Risk)

Sigma (Unsystematic Risk)

Income Stream Risk (Std of ROS)

Compensation Risk

Return on Sales (ROS)

Jensen’s Alpha

Board Chairman (O/l)

CEO Tenure

Firm Size (Log of Sales)

Model R2

F-Value

N

Parameter Estimate

-.Ol

-.02

-.01*

-.02***

.01*

-.Ol

.26***

.04

-.Ol

.15***

.38

49.4***

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Notes: t p<. IO

* PC.05

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*** p<.oo1

The model reported in this table has been corrected for fixed effects (by firm) and for heteroscedascity

across both firms and years. After the adjustments, no autocorrelation remained. Therefore, the dataset

was not adjusted for autocorrelation. The specifics of the adjustments made to the dataset are reported

in an appendix available from the second author upon request.





significance of the coefficients on the firm risk variables. As indicated in Table 3, all three risk coefficients (Beta, Sigma, and Income Stream Risk) are negative. Sigma and Income Stream Risk are significantly negative. This result is opposite that hypothesized, and provides evidence that higher risk firms actually pay less than lower risk firms. Note that the coefficients for Jensen’s Alpha (a measure of shareholder returns) and Firm Size are positive and strongly significant. This suggests that both firm size and shareholder returns are important determinants of total compensation.

Hypothesis 2 predicted that compensation level (total compensation) and compensation risk will be positively associated. This hypothesis is tested in Table 3 by the sign and significance of the Compensation Risk variable. As indicated in Table 3, the coefficient is positive and significant, providing support for Hypothe- sis 2. This result suggests that executives who accept more risk in their compensation arrangements tend to be more highly compensated than those executives with less risky arrangements.

The robustness of the evidence was examined by deleting some outliers in the data set and re-examining the results. Several executives in the sample received abnormally high total compensation in some of the years due to the timing of option grants. In order to test for the influence of these outliers, a second regression was estimated for Table 3. Executives whose total compensations exceeded three standard deviations from the mean were dropped. The exclusion of these outliers did not materially affect the sign or significance of any of the coefficients in Table 3.

Hypothesis 3 predicted that there will be a positive association between firm risk and golden parachutes, all else equal. The analysis presented in Table 4 tests this hypothesis with a discrete-time event history method (Allison, 1984). The sample reported in Table 4 codes a golden parachute dummy variable for each firm, each year. Firms are dropped from the sample after they adopt a golden parachute, as they are no longer at risk of subsequent adoption. This method of analysis permits us to update independent variables each year, yet avoid the biases of right-censoring. The resulting sample included 628 firm-years, and 30 golden parachute adoptions. As indicated in Table 4, none of the coefficients was significant, nor was the model itself significant. Thus, Hypothesis 3 receives no support from the analysis in Table 4.

Hypotheses 4 predicted a negative association between compensation risk and systematic risk, and Hypothesis 5 predicted a negative association between compensation risk and CEO stock ownership. The GLS analysis reported in Table 5 provides evidence on these hypotheses. The data reported in Table 5 have been corrected for fixed effects for both firm and year, and corrected for heteroscedascity across both firm and year. After these corrections, the Durbin- Watson statistic was 1.88, indicating that no correction for autocorrelation was needed.

The negative and very significant coefficient for Sigma (unsystematic risk) in Table 5 provides support for Hypothesis 4, but the coefficients on the other firm risk variables (Beta and Income Stream Risk) were not significant. Thus, Hypothesis 4 receives qualified support from the analysis reported in Table 5.

JOURNAL OF MANAGEMENT. VOL. 23, NO. 4, 1997




Table 4. Logistic Regression of Golden Parachutes Dependent Variable is Golden Parachute (O/l)

Variable Parameter Estimate

Intercept

Firm Return

Alpha

ROS

Firm Risk

Beta

Sigma

R & D Intensity

Advertising Intensity

Capital Intensity

Income Stream Risk

Ownership Percentage

CEO Age

Chairman (O/l)

CEO Tenure


Model Chi-square

N

-3.03

-.40

-.04

.12

.09

.04

.05

.Ol

-.25

-.07

.Ol

.47

-.07

-.lO

13.1 (13 df)

628

Nas: t p-c 10 * p<.o5 ** PC.01

*** p<.oo1

The negative and significant coefficient for CEO Ownership Percentage in Table 5 provides strong support for Hypothesis 5. CEOs who own more stock apparently receive less risky compensation arrangements than those who own less stock.

Hypotheses 6, 7, and 8 predict associations between compensation time horizon and strategic risk, CEO age, and CEO stock ownership, respectively. Evidence on those hypotheses is reported in Table 6. Like the earlier analyses, the regressions reported in Table 6 derive from a GLS methodology. Fixed effects and heteroscedascity have been corrected for, and the Durbin-Watson statistic on the model reported in the table is 1.99. This suggests that autocorrelation is not a problem.

Hypothesis 6, which predicted that compensation time horizon would be positively associated with strategic risk, receives weak support from the analysis reported in Table 6. The coefficients for R&D Intensity are positive and weakly significant in both models. Capital intensity is positive and not significant in one model (with age included as a continuous variable) and weakly significant in the





Table 5. GLS Regression Analysis of Compensation Risk

Dependent Variable Is Compensation Risk4

Variable Parameter Estimates

Intercept Strategic Risk

Beta (Systematic Risk)

Sigma (Unsystematic Risk)

Income Stream Risk (Std of ROS)


CEO Age


CEO Tenure


Model R2

F-Value

N

.07

1.10

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5.69**

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11,48***

750

Notes: 1_p<.10

* p<.o5

** p<.Ol

*** p<.ool

The model reported in this table has been corrected for fixed effects (by firm and by year) and for het-

eroscedascity across both firms and years. After the adjustments, no autocorrelation remained. There-

fore, the data set was not adjusted for autocorrelation. The specifics of the adjustments made to the data

set are reported in an appendix available from the second author upon request.

other model (with a retirement age dummy variable included in place of age). The coefficients on advertising intensity are not significant. Thus, support for Hypothesis 6 is quite weak. Because the three strategic risk measures all derive from ratios associated with firm size (all are scaled to firm sales), multicolinear- ity might be a problem. For that reason, individual models were analyzed, each including only one of the strategic risk measures (R&D Intensity; Advertising Intensity; and Capital Intensity). The results were not changed, however, in either sign or significance. Therefore, both models in Table 6 include all three strategic risk measures.

Hypothesis 7 predicted that CEO age would be positively associated with compensation time horizon because older CEOs would be more risk averse and, therefore, need more incentives to take risks. The evidence reported in both models of Table 6, however, is opposite that hypothesized, as both the coefficient for CEO age and the coefficient for the retirement age dummy variable are negative and significant. This evidence suggests that the ability of CEOs to influence their own compensation packages may be stronger than the ability of boards to put long-term incentive-based compensation schemes in place or strengthen those already in place.





Table 6. GLS Regression Analysis of Compensation Time

Horizon Dependent Variable Is Compensation Time Horizon’

Variable Parameter Estimates

Intercept Strategic Risk

R & D Intensity

Advertising Intensity

Capital Intensity

CEO Age

CEO Retirement Age (O/l)



CEO Tenure


Model R*

F-Value

N

-.03

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.05

.09

2.23**

.09

8.63***

750

.oo

.72?

-.16

.02t

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.04

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2.30***

.06

6.00***

750

Notes: tp<. 10

* p<.o5

** PC.01

*** p<.oo1

The model reported in this table has been corrected for fixed effects (by firm and by year) and for het-

eroscedascity across both firms and years. After the adjustments, no autocorrelation remained. There-

fore, the data set was not adjusted for autocorrelation. The specifics of the adjustments made to the data

set are reported in an appendix available from the second author upon request.

Finally, Hypothesis 8 predicted that CEO stock ownership would be nega- tively associated with compensation time horizon, as CEOs with large ownership positions would not need extra long-term incentives. The evidence in Table 6 strongly supports Hypothesis 8, as the coefficient for CEO Stock Ownership is negative and strongly significant in both models.

Discussion

Our study predicted that executives in high risk firms would receive higher compensation than those in lower risk firms. Our evidence, however, suggested the opposite. While ours is one of only a few which examine compensation risk and include a wide range of elements in the measurement of overall compensation, our results raise concerns. If high risk firms actually provide lower levels of compensation to their executives, then those firms should confront difficulties in attracting and retaining the best executive talent. This will be an important arena for future research.





We found no evidence to support our assertion that golden parachute adoption is more likely among high-risk firms. Our analysis, a discrete-time event history analysis, is a robust one for use in examining this problem. While the analysis was probably hampered by the relatively low number of adoption events in our sample, that number reflects the actual number of adoptions that occurred during the 1980s for our sample firms. Perhaps, as much of the earlier research suggests, firms that have received takeover interest are the primary adopters of golden parachutes. The role of golden parachutes in minimizing executive risk in day-to-day strategic decisions is apparently minimal for our sample.

Two important dimensions of compensation mix, compensation risk and compensation time horizon, were identified above. Compensation risk was defined as the extent to which the level of total compensation is uncertain. Compensation time horizon was defined as the extent to which the compensation arrangement provides rewards for the long-run firm performance. Our evidence suggests that high levels of compensation risk are generally linked to high levels of total compensation. We believe that the higher levels of total compensation represent a side payment to the executive for accepting the personal risk inherent in the compensation arrangement. The combination of high risk-high return pay schemes represents an important mechanism which furthers incentive alignment between owners and managers.

Compensation time horizon appears especially important when the firm’s primary strategy involves long-term investments (i.e., when the firm’s level of strategic risk is high). While our evidence provided only weak support, we believe that an important focus of executive compensation in firms requiring long-term investments is upon incentives which insure that the executives adopt and retain long-term perspectives. This is accomplished by a reward system based on firm performance over a multiyear time period.

The executive’s age may influence his or her risk propensity for long-term investments. The empirical results reported above, however, suggest that while CEO age is an important concern in setting compensation policy, older executives are provided with compensation contracts that put smaller proportions of their compensation at risk. As an executive nears the end of his or her career, risk propensity may decrease and influence the types of investment decisions made. Of course, our results may be explained by noting that older executives may have more influence on boards of directors, and therefore may receive compensation contracts in line with their personal preferences, rather than with the needs of the firm. As before, much more research is needed in this area.

A recurrent theme throughout this research has been the argument that the stockholdings of the executive have an important influence on the compensation contract. Large equity holdings by the executive may be thought of as substitutes for other arrangements which encourage risk taking. Executives who own substantial equity in the firm’s stock already bear large amounts of personal risk. Additional incentives from the compensation arrangement are thus redundant and unnecessary. Our evidence suggests that both compensation risk and compensation time horizon are importantly influenced (lessened) by large stockholdings. In





accord with our theory, stockholdings appear to act as a substitute for direct compensation incentives.

In summary, there are three important constructs to consider in the design of efficient executive compensation contracts. These include the compensation level, the amount of personal risk to the executive in the arrangement, and the extent to which the contract provides for long-term incentives. In addition, the executive’s age may affect his or her risk aversion and the executive’s stockholdings represents important influences.

Scholarly research necessarily involves tradeoffs and seldom approaches perfection. This research is no exception. Although every attempt has been made to examine the research questions in a comprehensive manner, some limitations should be mentioned. First, the research used only archival sources of data. The use of archival data is appropriate for measuring firm variables and for valuation of executive compensation. More difficult to defend, however, is the exclusive use of archival data for research questions involving the executives’ risk propensity. It may be necessary in the future to include subjective data, collected from interviews or questionnaires, in order to explore the risk propensity issue more fully. Second, the theory developed above ignores the influence of political factors on executive compensation. It may be, as Finkelstein and Hambrick (1989) have suggested, that political factors within the firm have relevance for a thorough understanding of the process through which executive compensation contracts are written and enforced. Indeed, our results on CEO age suggest that political factors may be quite important in establishing compensation policy. The exclusion of political factors is defensible in this research on the grounds that we did not focus on compensation process, but rather on the structure of compensation arrangements.

Conclusion

Despite more than thirty years’ research, executive compensation remains a fertile area of academic inquiry. Our research dealt exclusively with the compensation of Chief Executive Officers (CEOs), which has also been the focus of much of the earlier research. Very little research has been conducted on the determinants of the pay of executives below the level of CEO. It seems reasonable to speculate that if compensation is used to encourage a desired level of risk taking, however, that these incentives would extend to lower levels in the management team. Perhaps a useful approach would be to study the entire top management team’s composition in a reexamination of these issues.

The present study assumes that the level of risk taking that observers might presume to be appropriate is largely exogenous to the executive and the preferences of owners are revealed in the terms of the CEO’s compensation arrangement. This assumption itself may be investigated in future research. What happens, for example, when the firm’s environment, and hence its strategy, changes dramatically? Do recently deregulated firms significantly alter their compensation arrangements in a re-negotiation of this optimal level of risk taking? These questions provide fertile territory for researchers interested in executive compensation.





Acknowledgment: The authors wish to thank Abagail McWilliams and Asghar Zardkoohi for their helpful comments on earlier versions of this manuscript

Notes

1. While agency theory prescribes a strong association between organizational performance and CEO pay, some authors place more emphasis on the monitoring function of the board of directors (Walsh & Seward, 1990; Pound, 1992; 1995; Coffee, 1988) and, therefore, believe that pay may be dissociated from performance in some contexts,

2. While we have no evidence on the perceptions of CEOs regarding their personal investment, we see no reason why a CEO’s personal investment in a firm should be treated differently than any other shareholder’s investment in the firm. Gains made are simply returns to capital which could have been invested elsewhere, and should not be counted as part of the executive’s other compensation arrangements.

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