The influence of CEO risk tolerance on initial pay packages

Scott D. Graffin, Timothy D. Hubbard, Dane M. Christensen and Eric Y. Lee

Strategic Management Journal, 2020, vol. 41, issue 4, 788-811

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.

Date: 2020
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