Trade‐off Between Risk and Incentives: Evidence from New‐ and Old‐Economy Firms

Date01 January 2016
Published date01 January 2016
© 2016 Wiley Periodicals, Inc.
Published online in Wiley Online Library (
DOI 10.1002/jcaf.22122
Trade-off Between Risk and
Incentives: Evidence from
New- andOld-Economy Firms
Imen Tebourbi
The trade-off
between the incen-
tives offered to an
agent and the level
of risk imposed on
him, is a central issue
of principal-agent
theory. Agency
models predict that
executive compensa-
tion in firms with
more volatile stock
prices should be less
sensitive to stock
market performance
than executive com-
pensation in less
risky firms. This
means that execu-
tive pay-performance
sensitivity is decreas-
ing in the variance
of the firm’s per-
formance (Jensen
& Meckling, 1976;
On the other
hand, manage-
rial ownership
theory argues that in
uncertain environ-
ments, this relation
will not hold. In fact,
this theory suggests
that in risky settings,
it is more difficult
for the principal to
monitor the agent,
and this monitoring
difficulty would lead
the principal to us e
more performance-
based compensation
that would reward
the agent based on
the output (Dem-
stez & Lehn, 1985;
Prendergast, 2002).
In this case, the
relation between
pay- performance
sensitivity and risk
Empirical studies
failed to provide con-
vincing evidence on
the sensitivity of pay
to stock market per-
formance. While the
studies of Lambert
and Larcker (1987);
Aggarwal and
The sensitivity of managerial compensation to the
firm’s risk is a controversial issue. While some
articles find evidence supporting the agency theory
that predicts a negative relationship between pay‐
performance sensitivity and risk, others support
the managerial ownership that predicts a positive
relationship between these factors. This article
reconciles these theories and provides evidence
that these two theories are not conflicting, when
tested properly, using industries risk characteris-
tics. In this articled, we distinguish between new‐
and old‐economy industries, and demonstrate
that managerial ownership theory applies to new-
economy firms, which are high‐tech firms that
operate in more uncertain environments, whereas
the agency theory applies to old‐economy firms
that operate in more traditional industries. We fur-
ther control for the size effect and find a positive
relationship between pay‐performance sensitivity
and risk for medium and large size new-economy
firms. Furthermore, we find that high‐tech compa-
nies increased their CEOs noncash compensation
dramatically during the high‐tech market crash
between 2000 and 2002 to cushion the fall in their
CEOs wealth in the company. This caused CEOs
pay‐performance sensitivity to risk to become
negatively related to their firms’ risk during that
period. © 2016 Wiley Periodicals, Inc.
Editorial Review
54 The Journal of Corporate Accounting & Finance / January/February 2016
DOI 10.1002/jcaf © 2016 Wiley Periodicals, Inc.
Samwick (1999, 2002); and Jin
(2002) find evidence in favor
of trade-off theory, the studies
by Core and Guay (2001, 2002)
seem to support the managerial
ownership theory predictions.
The studies of Garen (1994);
Yermack (1995); Bushman,
Indejikian, and Smith (1996);
Ittner, Larcker, and Rajan
(1997); and Conyon and Mur-
phy (2000) test this relation but
fail to find statistically signifi-
cant results. On the other hand,
Jensen and Murphy (1990) find
results that are not economi-
cally significant.1 A study by
Dee, Lulseged, and Nowlin
(2005) finds mixed results.
Given these competing
arguments and opposing views,
our study’s goal is to shed light
on this debate by providing new
empirical evidence on the rela-
tion between pay-performance
sensitivity and risk. More spe-
cifically, we use a sample of
new- and old-economy firms
during the period of 1995 to
2007. Distinguishing between
these two types of industries
is important because they
have different risk attributes.
Moreover, our sample has two
advantages: (1) the long sample
period comprises a period
where the use of incentive
compensation became more
aggressive, at the point that
executive compensation became
heavily criticized; and (2) the
sample period is a period when
new-economy firms knew a
rapid growth. Ittner, Lambert,
and Larcker (2003) argue that
these firms strongly differ from
the old-economy firms as they
have smaller sizes in terms of
sales, assets, and number of
employees; invest more inten-
sively in research and develop-
ment; and have a more rapid
growth and lower marginal tax
ratesand accounting returns
than old-economy firms. More-
over, these firms rely more
heavily on stock-based com-
pensation (Anderson, Baker,
& Ravindran, 2000; Ittner et
al., 2003; Murphy, 2003); the
sample period includes a period
when the stock market crashed
(2000–2002) and it is interest-
ing to test whether this event
caused a change in executive
practices in a way that modifies
their pay-performance sensitiv-
ity to their firms’ performance.
This is, to the best of our
knowledge, the first attempt
that tests more properly mana-
gerial ownership and trade-off
theories. Prior research did not
distinguish between industries
based on their risk level. Our
findings suggest that conflicting
findings of exciting literature is
due to the heterogeneity in the
samples used. Industries partic-
ularities help explain the con-
tradiction between the trade-
off theory and the managerial
ownership theory. Our results
show a negative relationship
between pay-performance and
risk for old-economy firms,
which is consistent with the
trade-off theory and Aggarwal
and Samwick’s (1999, 2002)
findings. This relationship is
positive for the new-economy
firms, which is consistent with
managerial ownership theory
and Prendergast’s (2000, 2002)
arguments that the trade-off
theory does not hold in uncer-
tain environments, such as
high-tech firms. Moreover, our
results show the importance of
the size factor. First, we find
that small firms have higher
pay-performance sensitivi-
ties than large firms from the
same industries. Moreover,
we find that the positive pay-
performance sensitivity to risk
holds only for medium and
large new-economy firms. Our
results suggest that monitor-
ing problems that can occur in
uncertain environments does
affect small high-tech compa-
nies. We further test the robust-
ness of our results in different
market periods. We find strong
evidence suggesting that CEOs’
pay-performance sensitivity
becomes negative during the
market crash in 2000–2002 for
high-tech firms. This sensitiv-
ity is positive in the rest of
the sample period. Our results
illustrate that high-tech com-
panies increased the noncash
compensation of their CEOs
by 139% on average during the
market crash to cushion the
CEOs overall wealth loss in
their firms. Concurrently, all
return measures dropped
dramatically among these
high-tech firms.
The rest of this article is
organized as follows. The next
section reviews the studies
that examine the relationship
between pay-performance sen-
sitivity and risk and explains
the hypotheses to be tested.
The third section describes the
sample selection. The fourth
section specifies the meth-
odology and variables used.
The fifth section reports the
descriptive statistics and the
results of our empirical analy-
sis. The final section concludes
the article.
The formal agency model
of optimal contracting aims
at providing incentives to risk-
averse CEOs by tying their
compensation to shareholders’
wealth. Indeed, investment
opportunities and managerial
choice of actions are often not
observable to shareholders.
For these reasons the agency

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