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

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