Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 1 How Important Are Risk-Taking Incentives in Executive Compensation? Ingolf DittmannKo-Chia Yu Erasmus UniversityShanghai University of RotterdamFinance and Economics

Motivation: Relation between risk and incentives Informativeness principle (standard agency theory): – More risk  less incentive pay – Mixed empirical evidence (Prendergast, 2002) Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 2 Firm Risk CEO incentives

Motivation: Relation between risk and incentives Solid evidence that CEOs respond to risk-taking incentives – Hedging: Tufano (1996); Knopf et al. (2002) – Investments: Rajgopal and Shevlin (2002) – Leverage: Coles et al. (2006), Tchistyi et al. (2007) – Acquisitions: May (1995), Smith and Swan (2007) Stock and bond holders anticipate CEO risk-taking: DeFusco et al. (1990), Billett et al. (2006) Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 3 Firm Risk CEO incentives

Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 4 Research question Do shareholders provide risk-taking incentives on purpose? – Or are risk-taking incentives just an unimportant side effect of effort incentives? Is it important to take into account risk-taking incentives when designing a CEO compensation package?

Approach We model the endogeneity between risk and incentives Principal-agent model – Effort-averse agent chooses effort and firm strategy. – Firm strategy affects firm value and volatility. – Incorporate informativeness and risk-taking incentives Calibrate the model to individual CEO data. Model predicts – Optimal compensation structure for each CEO – Savings firms could realize by switching Compare model predictions with observed contracts Better than a model without risk-taking incentives? How Important are Risk-Taking Incentives in Executive Compensation 5Dittmann, Yu (2010)

Results (1) Consistence with compensation practice Savings from recontracting are small (mean: 10.4%) Average distance between the observed contract and the predicted contract is small. (mean: 8.0%) Much better fit than models with effort aversion alone – Dittmann & Maug (2007) find up to 54% savings and 28.8% difference in distances Conclusion: Risk-taking incentives play an important role in executive compensation practice. Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 6

Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 7 Results (1) Consistence with compensation practice

Results (2) Application: In-the-money options are optimal How Important are Risk-Taking Incentives in Executive Compensation 8 P W observed optimal    Replace stock & ATM options by ITM options Small savings Dittmann, Yu (2010) If U.S. taxes are taken into account: – Observed contract is optimal for 93% of the CEOs – Results consistent with the universal use of at-the-money options

The model: Standard assumptions Time t = 0: Contract is signed. Time T: End-of-period stock price P T is realized and wage w(P T ) is paid. Immediately after t = 0, the agent chooses effort e. – Firm value E(P T ) is increasing and concave in e. – Agent incurs costs of effort C(e) that are increasing and convex in e. Stock price is lognormally distributed. Agent is risk-averse (CRRA-parameter γ). How Important are Risk-Taking Incentives in Executive Compensation 9Dittmann, Yu (2010)

The model: Additional assumptions In addition to effort, CEO chooses firm strategy s. – Combination of many different actions (e.g., project choice, M&A, financial transactions) – Affects firm value E(P T ) and firm risk σ. Risk-averse CEO with monotonic wage contract will choose a strategy (s) that maximizes E(P T ) given σ. – Choice of s is equivalent to choice of σ. Reduced form: assume that CEO chooses σ. First-best strategy is associated with risk E(P T ) is increasing and concave in σ if E(P T ) is weakly decreasing in σ if How Important are Risk-Taking Incentives in Executive Compensation 10Dittmann, Yu (2010)

Principal-agent models with effort and risk-taking incentives Agent gathers information and makes project choice – Lambert (1986), Core & Qian (2002) Agent‘s effort affects mean and variance of stock price – Feltham & Wu (2001), Lambert & Larcker (2004) Continuous effort and volatility choice – Hirshleifer & Suh (1992), Flor, Frimor & Munk (2006) Models in continuous time – Hellwig (2008) assumes risk-neutral agent How Important are Risk-Taking Incentives in Executive Compensation 11Dittmann, Yu (2010)

The principal‘s problem How Important are Risk-Taking Incentives in Executive Compensation 12 Assume that first-order approach holds, so that the incentive compatibility constraint can be written as: Dittmann, Yu (2010)

Calibration method The full model cannot be calibrated to data, because P 0 (e,σ) and C(e) are unknown. Solve a simpler problem (first stage of Grossman and Hart, 1983): Search for a new contract with a given shape that – provides the same utility to the agent, – generates the same effort incentives, – provides the same risk-taking incentives, and – is as cheap as possible. If the model is correct, the new contract must be equal to the observed contract. How Important are Risk-Taking Incentives in Executive Compensation 13Dittmann, Yu (2010)

Dataset Construction Use CompuStat ExecuComp – Require 5 years of continuous history – Estimate wealth from previous years‘ income – Construct approximate option portfolios Aggregate into “representative option“ with same value, same option delta and same option vega We are left with 727 CEOs (for the year 2006). Estimate volatility from daily CRSP returns How Important are Risk-Taking Incentives in Executive Compensation 14Dittmann, Yu (2010)

Dataset: Descriptive Statistics Table 1 How Important are Risk-Taking Incentives in Executive Compensation 15Dittmann, Yu (2010) VariableMeanStd. Dev.10% QuantileMedian90% Quantile Stock (%)nS1.83%4.94%0.04%0.32%4.68% Options (%)nO1.37%1.62%0.14%0.92%3.17% Fixed Salary ($m)phi Value of contract ($m)pi , Non-firm Wealth ($m)W Firm Value ($m)P09,29422, ,38720,880 Moneyness (%)K/P070.1%21.7%41.2%72.0%100.0% MaturityT Stock Volatility (%)sigma30.0%13.4%16.4%28.3%45.5% Dividend Rate (%)d1.24%2.25%0.00%0.63%3.30% Age Return (%) 11.8%15.6%-5.7%11.4%28.7%

Optimal Contracts with Risk-Taking Incentives Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 16 Table 3

Optimal Contracts that Consist of Salary, Stock, and Options Consider contracts that consist of base salary, stock and one option grant. Principal minimizes contracting costs over – Base salary – Number of shares – Number of options – Option strike price How Important are Risk-Taking Incentives in Executive Compensation 17Dittmann, Yu (2010)

Optimal Contracts that Consist of Salary, Stock, and Options Table 6 Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 18

In-the-money options and the U.S. tax system IRC 409A: Executives must pay a 20% penalty tax on the intrinsic value of the option when it becomes exercisable. – Neglect other rules like IRC 162(m). Repeat analysis with this tax penalty – Observed contract is optimal for 76% to 93% of all CEOs (depending on assumptions) – US tax system prohibits in-the-money options. How Important are Risk-Taking Incentives in Executive Compensation 19Dittmann, Yu (2010)

Robustness test: Loss-Aversion Utility Function Dittmann, Maug, Spalt (2010) showed that if CEOs are loss-averse, the principal agent model is able to explain current compensation practices. Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 20

Optimal Contracts with Loss-Aversion Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 21

Loss Aversion with Risk-Taking Incentives Dittmann, Yu (2010) How Important are Risk-Taking Incentives in Executive Compensation 22

Conclusions Optimal compensation structure from a principal-agent model where the agent chooses effort and firm-volatility Model performs much better than a model w/o risk-taking incentives. – Small savings (10.4% vs. 54% w/o risk-taking incentives) – Small distance from observed contract (8% vs. 28.8% w/o risk-taking incentives) – Optimal contract is convex over some regions Risk-taking incentives are not a issue in LA models, but the RTI explanation is less susceptive to parameter choices. Risk-taking incentives are a major objective in executive compensation practice. How Important are Risk-Taking Incentives in Executive Compensation 23Dittmann, Yu (2010)