CEO overconfidence and corporate risk taking: Evidence from pension policy

AuthorJoohyung Ha,Carol M. Graham,Cathy S. Goldberg
Date01 October 2020
Published date01 October 2020
CEO overconfidence and corporate risk taking: Evidence
from pension policy
Cathy S. Goldberg | Carol M. Graham | Joohyung Ha
School of Management, University of San
Francisco, San Francisco, California
Cathy S. Goldberg, School of
Management, University of San Francisco,
San Francisco, CA.
We examine the relationship between managerial overconfidence and corporate
risk taking. More specifically, we investigate how overconfidence affects the risks
that CEOs take in managing their firm's pension plans. Using both options-based
and firm-based measures to proxy for CEO overconfidence, we find that over-
confident CEOs are more likely to take on greater risk in managing their pension
plans by increasing the amount of pension assets invested in equities and the vola-
tility of the pension fund. Our results are significant in the post-global financial cri-
sis of 2008 during a period when data indicates average equity allocation in pension
assets decreased thus highlighting that overconfident managers behaved contrary to
the overall market. This study adds to the literature on both managerial over-
confidence and its consequences, and on the drivers of corporate pension policy.
CEO overconfidence, pension plans, risk taking
Research shows that overconfidence leads corporate
managers to take risk.
This dynamic of overconfidence
leading to risk manifests itself in a host of corporate poli-
cies where CEOs have discretion. This article examines
overconfidence in the context of pension policy, building
upon similar studies of managerial overconfidence in
other areas of finance, such as merger activity, dividend
payout, earnings management, and earnings forecasts.
CEOs tend to be overconfident; they take more risk and
are more optimistic than the general population. Further-
more, these personal traits affect corporate financial policies
(Graham et al., 2013). Levels of optimism have differential
effects on how managers approach investing (Campbell
et al., 2011). Because overconfident managers underesti-
mate downside risk and overestimate expected cash flows
from investments, they are more likely to increase corpo-
rate risk relative to other CEOs (Banerjee et al., 2015).
Roll (1986) first introduced overconfidence (or the
hubris hypothesis) in finance as a possible explanation
for some of the observed differences between the theory
and practice of managers with respect to takeover activ-
ity. Since Roll's study, the firm-level consequences of
managerial overconfidence have been the focus of a large
number of studies in accounting and finance. Previous
research has found that managerial overconfidence
affects key investment and financing decisions.
Malmendier and Tate (2008) examine the impact of over-
confidence on merger activity. Since overconfident man-
agers overestimate their ability to generate returns, they
note that managers pay too much for target firms. Their
results indicate that overconfident managers make riskier
investment decisions that consequently destroy value for
shareholders. This is especially true when they have
available internal financing and do not need to resort to
external financing. In a complementary study, Campbell
et al. (2011) show that low, moderate and high levels of
optimism have differential effects on how managers
approach investing. With regards to financing activities,
Malmendier and Tate (2005) find that overconfident man-
agers are less likely to seek external financing, and equity
Received: 21 December 2019 Revised: 3 August 2020 Accepted: 18 August 2020
DOI: 10.1002/jcaf.22470
J Corp Acct Fin. 2020;31:135153. © 2020 Wiley Periodicals LLC 135
financing in particular, because they believe that these
sources of financing are overpriced. Overconfident man-
agers are likely to use more debt (in particular short-term
debt) and have a lower likelihood of paying dividends.
Sunder et al. (2010) further investigate the impact of over-
confidence on debt contracts and find that for merger-
related activities, overconfident CEOs are more likely to
experience restrictions on their investing activities as
reflected in debt covenant design.
Aside from key investment and financing decisions,
research also shows that managerial overconfidence has
an impact on financial reporting and forecasting. Ahmed
and Duellman (2012) examine whether overconfidence is
associated with accounting conservatism and find a nega-
tive and significant relationship even after controlling for
known determinants of conservatism. Prior studies also
show that not only is there a positive relationship
between managerial overconfidence and the decision to
issue voluntary forecasts, but that overconfidence affects
the accuracy of the forecasts and leads managers to inject
more of an upward bias into their forecasts. (Libby and
Rennenkemp (2011), and Hribar and Yang (2016)). Fur-
thermore, this optimistic bias appears to have a cascade
effect that manifests itself in earnings management
behavior (Schrand and Zechman (2012)).
More than a decade ago, Ben-David et al. (2007) argued
that theeffectofoverconfidenceshouldbeexplicitly
modeled when analyzing corporate decision-making.From
the research summarized above, it is clear that the impor-
tance of individual heterogeneity in corporate finance and
corporate governance has indeed become a primary focus in
behavioral finance (Graham et al., 2013) and can potentially
help explain a wide variety of corporate decisions.
Given that prior research has consistently docu-
mented the impact of managerial overconfidence on key
investment and financing decisions, we anticipate that
managerial overconfidence will also have an impact on
the risks that CEOs take with regard to the pension plans
that they manage.
The paper is structured as follows: Section 2 provides
our hypotheses development. Section 3 outlines our
research design and sample selection. Descriptive statistics
are included in Section 4. Section 5 provides a discussion
of our empirical results and Section 6 concludes the paper.
2.1 |The context of pension plans
Our study focuses on the impact of managerial over-
confidence and risk taking in the context of pension plan
investment risk. It is widely understood that managers
can exercise discretion with pension-related assumptions
and pension funding in both the private and public sec-
tors. Comprix and Muller III (2011) argue that due to the
lack of specific guidance in the Accounting Standards
Codification (ASC) 715: Compensation-Retirement Bene-
fit (Financial Accounting Standards Board, 2009) that
governs pension-related accounting issues, private com-
panies have considerable discretion over the choice of
pension-related assumptions. Bonsall et al. (2019) argue
that, at the state level, gatekeepers such as auditors or
actuaries do not play an important role in limiting the
opportunistic use of pension plan assumptions due to
their limited market power. Furthermore, the extant liter-
ature shows that managerial incentives affect pension
strategy. For example, Anantharaman and Lee (2014)
find that the structure of executive compensation affects
risk shifting through pension underfunding and the allo-
cation of pension assets to risky securities.
Given that managers can exercise considerable discre-
tion over pension plan assets and the assumptions under-
lying pension-related liabilities, the factors that influence
the risk taken by managers in this context is arguably an
important area of interest. We investigate whether CEO
overconfidence can explain risk taking as reflected in the
asset allocation decisions of managers and subsequent
volatility of fund portfolios. Our results indicate that
overconfidence is directly and significantly, related to
pension investment risk.
By examining overconfidence and risk-taking in the
context of pension accounting, our paper adds to the lit-
erature on both the effects of managerial overconfidence,
and on pension policy drivers. As far as we are aware,
our study is the first to investigate these issues in tandem.
2.2 |Hypotheses development
Previous research on defined-benefit pensions has exam-
ined factors that affect variations in pension fund invest-
ment strategies such as tax provisions (Black, 1980;
Frank 2002; Tepper 1981), compensation structures
(Anantharaman & Lee, 2014), economic factors and
sponsor firm characteristics (Bartram, 2018). Evidence
from this stream of research remains mixed, however,
and calls for further research in the area of pension fund
policies and investment strategies persist (Rauh, 2009;
Bartram, 2018). What previous defined-benefit pension
studies have neglected to focus on, are the behavioral
characteristics of those who manage, and exercise discre-
tion over the fund.
Malmendier and Tate (2008) show that overconfident
managers overestimate their abilities to generate returns
and thus overpay for merger targets. Along these same

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