The influence of CEO risk tolerance on initial pay packages

• Author: Timothy D. Hubbard,Eric Y. Lee,Dane M. Christensen,Scott D. Graffin
• Date: 01 April 2020
• DOI: http://doi.org/10.1002/smj.3112
• Published date: 01 April 2020

RESEARCH ARTICLE

The influence of CEO risk tolerance on initial pay

packages

Scott D. Graffin

1

| Timothy D. Hubbard

2

| Dane M. Christensen

3

|

Eric Y. Lee

1

1

Terry College of Business, University of

Georgia, Athens, Georgia

2

Mendoza College of Business, University

of Notre Dame, Notre Dame, Indiana

3

Lundquist College of Business, University

of Oregon, Eugene, Oregon

Correspondence

Scott D. Graffin, Terry College of Business,

University of Georgia, 600 S. Lumpkin

Street, Athens, GA 30605.

Email: sgraffin@uga.edu

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 fol-

low this recommendation, or instead receive pay packages

that mirror their risk preferences. Rather than finding sup-

port 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 counter-

parts. 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

Received: 4 June 2018 Revised: 6 September 2019 Accepted: 10 October 2019 Published on: 1 December 2019

DOI: 10.1002/smj.3112

788 © 2019 John Wiley & Sons, Ltd. Strat Mgmt J. 2020;41:788–811.wileyonlinelibrary.com/journal/smj

risk-seeking CEOs' strategic actions are more strongly

influenced by performance-based pay, while more risk-

averse CEOs seem relatively unaffected by pay mix.

KEYWORDS

agency theory, CEO pay, compensation, political orientation, risk

tolerance

1|INTRODUCTION

Due to the separation of ownership and control, numerous governance mechanisms are put in place

to encourage managers to act in the best interests of owners (Berle & Means, 1932; Fama & Jensen,

1983; Jensen & Meckling, 1976), the most visible of which is a CEO's compensation contract. Pre-

scriptions for how to structure CEO compensation to achieve this end are usually based on the behav-

ioral assumptions of agency theory and focus on designing pay schemes to overcome the CEO's risk

aversion (Hölmstrom, 1979). Despite such straight-forward assumptions regarding CEO pay prefer-

ences, research finds weak and mixed support regarding the effectiveness of CEO compensation

schemes as a corporate governance mechanism (Devers, McNamara, Wiseman, & Arrfelt, 2008;

Finkelstein, Hambrick, & Cannella, 2009; Hayes, Lemmon, & Qui, Hayes, Lemmon, & Qiu, 2012).

One reason for these mixed findings may be that CEO's vary in how they respond to compensa-

tion schemes. Consistent with upper echelons theory, which suggests that CEO characteristics influ-

ence how they respond to their environments (Hambrick, 2007; Hambrick & Mason, 1984), the

effectiveness of CEO compensation schemes likely depends on CEOs' characteristics such as their

values, experiences, and personality (Wowak & Hambrick, 2010). Given the importance of paying

CEOs to motivate them to act in the best interest of shareholders, better understanding how CEO

characteristics influence compensation schemes is critical to the strategic management literature. This

important topic, however, has not received direct attention in management research and is thus

poorly understood. This lack of attention may be driven by the difficulty of finding an accurate ex

ante indicator of a newly appointed CEO's characteristics, such as their attitude toward risk.

Addressing the match between CEOs' risk preferences and their initial compensation scheme is

our focus. To do so, we capture a newly appointed CEO's political orientation, as it “represents an ex

ante measure of an executive's attitude toward risk”(Christensen, Dhaliwal, Boivie, & Graffin, 2015:

p. 1919), which research suggests is an unobtrusive and stable ex ante measure of the executive's risk

propensity (cf. Christensen et al., 2015; Hutton, Jiang, & Kumar, 2014). A meta-analysis on political

orientation concludes that those who are more conservative are more risk averse and more liberal

individuals are more risk seeking (Jost, Glaser, Kruglanski, & Sulloway, 2003). This relationship

also finds support in the executive suite as firms led by Republican-leaning executives tend to engage

in less-risky investments (Hutton et al., 2014) and in less tax avoidance (Christensen et al., 2015).

Using this ex ante indicator of an individual's risk preferences allows us to examine vital, yet still

unanswered questions, regarding a newly appointed CEO's initial compensation structure.

Specifically, do newly appointed CEOs receive pay packages that encourage or discourage their

inherent risk taking preferences? Or, in other words: Do risk-averse CEOs receive more incentive-

laden plans to overcome their risk aversion, consistent with agency theory-based recommendations?

And do risk-seeking CEOs receive less incentive compensation to avoid inducing excessive risk

GRAFFIN ET AL.789