Corporate Executive Pay Programs Encourage Risk Reduction

June 4, 2009
New Watson Wyatt study found that high levels of stock ownership were associated with reduced risk, and excessively high levels of pay opportunity encourage taking more risk.

Many elements of corporate executive pay programs believed to cause excessive risk taking actually encourage executives to reduce risk, according to a study by Watson Wyatt.

"Many believe that executive pay played a substantial role in the financial crisis by encouraging excessive risk taking. As a result, public support has swelled for reforming and regulating the basic executive pay model," said Ira Kay, global director of executive compensation at Watson Wyatt. "However, traditional methods for evaluating executive compensation risk do not accurately gauge the true relationship between risk and pay."

Watson Wyatt evaluated the executive compensation architecture at more than 1,000 firms and identified elements of executive pay programs that encourage or discourage corporate risk taking. Surprisingly, many of these contradict widely held beliefs, including the common critique that high incentive levels encourage reckless risk taking.

Similarly, conventional wisdom would hold that higher amounts of annual bonuses, long-term incentives (LTIs) and stock options encourage excessive risk taking. However, the Watson Wyatt analysis found that these actually encourage executives to take less risk.

In some instances, pay elements that encourage more or less risk taking behavior conform to conventional wisdom. High levels of stock ownership were associated with reduced risk, and excessively high levels of pay opportunity encourage taking more risk.

"Finding a way to assess risk taking will have a significant impact on the next generation of executive pay plans," said Kay. "Ultimately, the companies that find the sweet spot between executive pay for performance and rewarding proper risk management will be better positioned to reward and motivate executives while delivering higher long-term shareholder returns."

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