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

Abstract

This paper analyzes the risk-taking properties of long-term incentive plans based on relative performance. In stark contrast to traditional time-vested stock options, these incentive plans give undiversified, risk-averse managers an incentive to pursue projects characterized by idiosyncratic rather than systematic risk. My key prediction is that this effect manifests synergistically through two plan characteristics: payout convexity and peer group difficulty. I present empirical evidence consistent with this prediction. I further show that the choices for payout convexity and peer group difficulty are consistent with moral hazard considerations. Collectively, my study highlights several new dimensions to consider in assessing whether and how incentive-compensation contracts alter firms’ risk profiles.

Keywords: relative performance evaluation, idiosyncratic risk, convexity, peer selection, executive compensation

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