Friday, October 26, 2012

CEO pay and risk-taking

Aligning CEO pay with risk is one of the challenges of governance today; the failure to do so has been cited as one of the reasons for the financial crisis of 2007. How do we bring about this alignment? An article in HBR (The life cycle of CEO compensation, October, 2012) has some interesting ideas.

The article suggests that using an appropriate mix of stocks and stock options (instead of a pre-determined or set mix) might help. Options lead to an increase in prospective wealth and hence encourage risk-taking; stocks, which are current wealth, discourage risk-taking; the greater the stocks, the greater the aversion to risk because CEOs don't want to lose what they have.

It follows that CEOs will take big risks at the beginning of their careers when their option holdings are high and wealth holdings low; their appetite for risk will fall with time. If you want the firm to take risks and the CEO is at the end of his term, it would be best to expedite his departure and bring in a newcomer. If the firm is being too conservative and you want to encourage risk-taking, give lots of options to the CEO. In general, it's a good idea to set a ratio for holdings of stocks and options so that the appetite for risk is optimal.

In a post below, I pointed to research which suggests that leaders from outside are more likely to take gambles. If you want to encourage this further, give outsiders stock options; if you want a check on it, give the outsider lots of stocks.

2 comments:

Sandra sue said...

i saw your post, through the subject is new too me,its easy to understand the facts behind this.

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