Risk Premia in Executive Compensation: A Life-Cycle Perspective

Abstract

This paper employs a life-cycle model of consumption and saving to study risk premia in CEO compensation, and compares them to variation in observed pay levels. The model incorporates the main types of risk to income and savings that executives of public corporations typically face: option- and stock-based pay, pay-performance sensitivity, dismissal risk, and stock return volatility. A calibration to a large panel of US CEOs shows that, for realistic degrees of risk aversion, risk premia can explain about 20 percent of the cross-sectional variation in CEO pay, and between 10 and 20 percent of the evolution of average pay levels over time. Thus, increases in risk exposures can only partially explain the surge in executive pay levels over the past decades. In contrast, the model captures very well the skewness of the cross-sectional pay distribution.

Keywords: CEO compensation, incentive compensation, risk premia, life-cycle models

JEL Classification: G30, D91