What are the Risk-Taking Properties of Long-Term Incentive Plans Based on Relative Performance?

71 Pages Posted: 29 Apr 2020 Last revised: 2 Nov 2022

Date Written: November 2, 2022

Abstract

Incentive plans based on relative performance strip away systematic performance trends and provide managers with an incentive to select projects characterized by idiosyncratic rather than systematic risk. Here, I show theoretically and empirically that such a plan’s payout structure can alter this incentive to pursue idiosyncratic risk. When payouts are in shares—and tied to the firm’s stock price—the ultimate payout remains a function of systematic performance, reducing the incentive to pursue idiosyncratic risk. This effect does not manifest when payouts are in pre-specified amounts of cash. I further show that the differential risk-taking incentive of share- and cash-based relative performance plans is a function of expected relative performance and the plan’s incentive strength. This paper brings in the idea that relative performance plans might not always encourage managers to pursue innovative projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available.

Keywords: idiosyncratic and systematic risk, relative performance evaluation, cash bonuses, payout convexity, executive incentive-compensation

JEL Classification: G30, J33, J41, M12, M41

Suggested Citation

Timmermans, Oscar, What are the Risk-Taking Properties of Long-Term Incentive Plans Based on Relative Performance? (November 2, 2022). Available at SSRN: https://ssrn.com/abstract=3570875 or http://dx.doi.org/10.2139/ssrn.3570875

Oscar Timmermans (Contact Author)

London School of Economics ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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