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

Abstract

Relative performance plans strip away systematic performance trends and give managers incentives to increase their firms’ risk more by increasing idiosyncratic rather than systematic risk—but only if payouts are in pre-specified amounts of cash. Share-based payouts are still a function of systematic performance and give incentives to focus on systematic risk—which managers can hedge by trading the market portfolio. Empirical evidence is consistent with this prediction. Collectively, this paper brings in the perspective that relative performance plans might not always encourage managers to pursue innovative projects, which are primarily characterized by idiosyncratic risk.

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

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