How Does CEO Age Affect Firm Risk?

• DOI: http://doi.org/10.1111/ajfs.12174
• Date: 01 June 2017
• Published date: 01 June 2017

How Does CEO Age Affect Firm Risk?

Jaideep Chowdhury*

Department of Finance and Business Law, James Madison University, United States

Jason Fink

Department of Finance and Business Law, James Madison University, United States

Received 20 October 2015; Accepted 21 November 2016

Abstract

Previous research demonstrates that older CEOs are associated with lower firm equity risk

and fewer R&D expenditures. We examine the risk-taking behavior of CEOs and find that

not only do older CEOs invest in less R&D, they do so sub-optimally, in the sense that CEO

age distorts the effect of qon R&D investment decisions. We find that it is specifically

through the channel of R&D investment that CEO age is associated with the reduction in

firm equity risk. Consistent with the sub-optimality of these distortions, firms with more

effective corporate governance do not exhibit these associations.

Keywords CEO age; Corporate governance; Idiosyncratic risk; R&D expenditure; Systematic

risk

JEL Classification: G30, G32

1. Introduction

Several studies tie the age of the CEO to various corporate policies and firm risks.

Recently Serfling (2014) found that older CEOs are associated both with lower

firm equity risk and with lower R&D expenditures (which are generally riskier

than other firm investments), and presents evidence that CEO age is even causal

in this reduction in risk. Further, several other articles have found that older

CEOs are associated with lower R&D expenditures.

1

Establishing that older CEOs

possess these biases is valuable, but what is not established is whether these biases

tend to be beneficial or detrimental to the firm. It may be that a reduction in firm

investment policy risk is precisely the reason older CEOs tend to be brought in to

firms. Alternatively, it may be that this reduction in risk is deleterious to the

profit potential of the firm and that the lower risk of older CEOs is the price to

*Corresponding author: Jaideep Chowdhury, Department of Finance and Business Law, James

Madison University, Harrisonburg, VA 22801, USA. Tel: +1-540-250-7285, Fax: +1-540-568-

3017, email: chowdhjx@jmu.edu.

1

See, for example, Lundstrom (2002) and Levi et al. (2010).

Asia-Pacific Journal of Financial Studies (2017) 46, 381–412 doi:10.1111/ajfs.12174

©2017 Korean Securities Association 381

be paid for their experience and ability to generate profit for the firm in other

ways. This would imply that efforts to mitigate that price should be actively

undertaken.

We investigate the nature of these findings, and discover several important asso-

ciations that suggest that the lower risk associated with older CEOs is indeed detri-

mental to the firm. Specifically, we find that not only are older CEOs associated

with lower R&D expenditures, but also that they distort the relationship between

growth opportunities and R&D expenditures, which implies suboptimal profitability

for the firm (see Hayashi, 1982 and Hubbard, 1998 for theoretical models describ-

ing the relationship between growth options and firm investment). Specifically, for

older CEOs, an increase in the firm’s growth options produces less R&D investment

than is the case for younger CEOs.

Extending Serfling (2014), we also find that R&D expenditures appear to be

the channel by which the age of the CEO is associated with firm equity risk.

When a variable interacting CEO age with R&D expenditures is included in

regressions explaining firm equity risk, the interaction variable is statistically and

economically significant. This effect is important. For example, we will show that

for a 40-year-old CEO, a one standard deviation increase in R&D equates to a

15.70% increase in systematic risk for the firm. However, for a 65-year-old CEO,

the same R&D increase is associated with a 4% increase in the systematic risk of

the firm. However, when we control for this interaction, direct associations

between CEO age and equity risk are no longer significant. This is in contrast to

Serfling (2014) who report a direct negative relationship between CEO age and

equity risk of the firms.

Our findings are important to the understanding of firm management, invest-

ment, and risk, but perhaps most importantly as a corporate governance issue.

Chauvin and Hirschey (1993) found that R&D expenditures have a large and

positive effect on the value of the firm. Further, Eberhart et al. (2004) find that

unexpected R&D increases result in positive abnormal returns. Suboptimal R&D

expenditures are likely to hurt firm value. Consistent with this, we find that

good corporate governance eliminates the distortion that age creates in the sensi-

tivity of R&D to growth options. We measure “good corporate governance” in a

variety of ways—through the use of an earnings management measure, through

the use of a free cash flow measure, and by using the Herfindahl Index. In all

cases, the distortion of CEO age in the sensitivity of R&D to growth options is

absent among well-governed firms. This contrasts importantly with the conclu-

sion of Serfling (2014), who asserts that firms may want older CEOs to take

fewer risks.

Further, we see evidence of an indirect relationship between the age of the CEO

and firm risk that relates to R&D expenditures. While Serfling (2014) found that

older CEOs reduce total and idiosyncratic firm risk, we find that for well-governed

firms, CEO age does not affect the systematic or idiosyncratic risk of the firm,

J. Chowdhury and J. Fink

382 ©2017 Korean Securities Association

either directly or indirectly. In contrast, for poorly governed firms, CEO age affects

the systematic and idiosyncratic risk through the channel of R&D.

2

Numerous studies tie CEO characteristics and compensation to the behavior of

the firm. For example, using a sample of US firms between 2005 and 2008, Huang

et al. (2012) found a positive association between CEO age and reporting quality,

and a negative association with CEO age and firms’ ability to meet or beat analyst

earnings expectations. Hirshleifer et al. (2012) found that overconfidence in man-

agers is tied to innovation for a sample of US firms. Using a sample of S&P 500

firms, Yim (2013) found that firms governed by young CEOs are more inclined to

undertake corporate acquisitions.

Empirical studies related to the investment choices of older and younger CEOs

are widespread. In an influential study, Dechow and Sloan (1991) found that R&D

expenditures are significantly lower in a CEO’s final years of employment. Consis-

tent with the managerial myopia conclusions of Barker and Mueller (2002), Lund-

strom (2002) found that older CEOs invest less in R&D. Naveen (2006) found that

R&D expenditures are negatively associated with CEO tenure. Cheng (2004), how-

ever, found that boards are effective in designing compensation schemes for CEOs

that reduce the incentives to suboptimally allocate R&D expenditures. This impor-

tant finding provides an indication of the endogenous relationship between CEO

pay and investment levels. Hirshleifer and Thakor (1992) found that managers at

the end of their career are more conservative, and that this conservatism may be

good for the firm. Kini and Williams (2012) found that tournament incentives drive

executives to take on greater firm risk.

That the characteristic of CEO age influences R&D expenditures in particular,

and firm risk in general, is well documented. Although the empirics put forth in

recent articles suggest that older CEOs tend to pursue less risky policies, there are

several competing theories. As is well described in Serfling (2014), one such set of

theories is related to managerial career concerns. For example, Scharfstein and Stein

(1990) and Holmstrom (1999) argue that younger managers are concerned they

may face greater labor market challenges if they make a bad decision early in their

careers, and thus are induced to be more risk-averse. However, several other theo-

ries have been put forth as to why older CEOs may be more risk-averse. These

explanations include the myopia of older CEOs (Barker and Mueller, 2002), and a

desire to limit the risk of retirement benefits (Kalyta, 2009). Prendergast and Stole

(1996) suggest that young executives try to signal their quality to the market with

risky policies.

While there is a host of literature that ties the age or experience of the CEO of

a firm to R&D, there is less work that ties R&D to the risk of the firm. Nonetheless,

this relationship is established. For example, Ho et al. (2004) find that R&D is

2

Unreported, we also find that our results are robust to recent findings that overconfidence is

related to innovation (Hirshleifer et al., 2012). When we control for the overconfidence mea-

sure of Malmendier and Tate (2005), our findings continue to hold.

CEO Age and Firm Risk

©2017 Korean Securities Association 383