Analysis Presents New Correlations between Exec Pay and Risk Taking

June 4, 2009 ( - Many elements of corporate executive pay programs believed to cause excessive risk-taking actually encourage executives to reduce risk, according to experts at Watson Wyatt, a global consulting firm.

According to a press release, Watson Wyatt’s evaluation of the executive compensation architecture at more than 1,000 firms and their correlation to corporate risk-taking revealed findings that contradict widely held beliefs, including the common critique that high incentive levels encourage reckless risk taking.

Similarly, conventional wisdom says higher amounts of annual bonuses, long-term incentives (LTIs) and stock options encourage excessive risk taking; however, the analysis found that these actually encourage executives to take less risk, the release said.

According to the analysis, high levels of stock ownership are associated with reduced risk, and excessively high levels of pay opportunity encourage more risk taking.

To evaluate the potential risk, Watson Wyatt employed in its correlations the Z-score, a widely used measure to assess credit risk.

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Correlation of Executive Pay Elements With Risk Taking

Risk Aggravators

Risk Neutral

Risk Mitigators

Excessive pay opportunity

Use of earnings-based metrics in annual incentive plans

High proportion of LTI in total direct compensation

Use of a number of performance metrics in annual incentive (bonus) plans

High levels of nonqualified deferred compensation

Use of market-based metrics in annual incentive plans

Use of return-based metrics in annual incentive plans

Longer vesting terms (years) for LTIs

High annual incentive leverage

Higher proportion of options in LTI mix

Source: Watson Wyatt