Well-compensated CEOs with millions of dollars in stock options in their back pockets may be inclined to take greater investment risks. But they also face a higher likelihood of facing big losses than big gains, according to a new study co-authored by a Brigham Young University professor.
"It puts blinders on their consideration of downside risk," said W. Gerard Sanders, an associate professor of strategic management at BYU's Marriott School of Management.
Sanders and Donald C. Hambrick of Penn State University reached the conclusion after analyzing executive pay packages, company investments and financial performance at 950 randomly selected companies.
Options-heavy CEOs are "almost three times as likely to suffer big losses as benefit from big gains," Sanders said. "There's a very disproportionate chance of losing when a CEO is option-heavy."
Stock options are the largest component of executive pay in the United States, the study notes, and are intended to foster "managerial aggressiveness" in top bosses. However, because they are not tied directly to performance or outcome, they tend to encourage overly risky behavior that rarely pays off.
"It's not always bad," Sanders said. "In some cases they do hit home runs. It's just that you're more likely to strike out."
According to the authors, high levels of CEO stock options and high levels of investment produce what they term a "combustible combination" that results in "very extreme outcomes" in companies' share prices.
Sanders compared the situation to gambling with a stranger's money most people would be willing to bet big, and risk losing big, because they don't have a true financial stake in the outcome.
Executive stock options have their place in moderation, the professors conclude, but suggest more appropriate forms of compensation, such as replacing stock options with restricted stock or offering basic annual bonuses.
"We're not saying cut back on the CEOs' level of pay. We don't look at that at all," Sanders said. "This isn't a story on how much they're paid, it's how they're paid."The study, published in the October/November issue of the Academy of Management Journal, is the first of its kind to look at the overall system of options and how they work. The peer-reviewed publication is published every other month by the academy, which has some 18,000 members in more than 100 countries.