DP15243 Are CEOs paid extra for riskier pay packages?

Author(s): Rui Albuquerque, Ana Albuquerque, Mary Ellen Carter, Flora Dong
Publication Date: September 2020
Date Revised: December 2020
Keyword(s): ARCH, CEO pay, Contract Theory, Incentive Lab, incentives, moral hazard, participation constraint, realized variance, risk aversion
JEL(s): D81, G30, J33, M52
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15243

This paper quantifies the cost of CEO incentive compensation by estimating an elasticity of pay to the variance of pay. This metric is based on the benchmark moral hazard model widely used to study CEO pay. Using US CEO compensation data and a variety of empirical approaches, we find that CEOs with riskier pay packages are paid more. However, the estimated elasticity of pay to the variance of pay is small. This small elasticity implies a low risk aversion coefficient for CEOs and a risk premium that is at most 12% of total pay. This risk premium is about evenly split between compensation for risk in cash bonus, stock grants, and option grants. Overall, our findings suggest that incentive pay is not too costly for firms from a risk-diversification perspective, which may explain the heavy reliance on incentive pay by US firms, and cast doubt on the ability of the benchmark moral hazard model to explain CEO pay in the US.