Firms set terms and perks by seniors' personality traits

Companies appear to structure compensation contracts and incentive pay based on seniors' personality traits and not just firm characteristics, a team of US researchers, including an Indian-origin scientist, has found.

Companies offer incentive-heavy compensation contracts to overconfident CEOs to "exploit" their positively biased views of the firms' prospects, the researchers noted.

"There are divergent views on the use of options and stock in CEO compensation contracts: Do they appropriately incentivise managers and enhance shareholder value and if so, why is there much variation in their use across firms?" said Vikram Nanda from Naveen Jindal School of Management in the US.

The notion is that if managers and shareholders -- represented by the board -- have a different take on a firm's prospects and CEO talent, there will be greater use of incentive pay that the managers value highly but the board regards as less costly.

"When you think about incentive contracts, you don't usually think about the personality of the individual being a factor in the contract," Nanda added in the paper published in the Journal of Financial Economics.

Using the compensation data of CEOs between 1992 and 2011, the researchers identified managers who were exhibiting behaviour that was overconfident compared to other CEOs.

"You don't usually hear about how two profit-sharing agreements are going to look different because the personalities and the beliefs of the individuals are coming into play," Nanda stated.

The team conducted empirical tests to explore the relationship between CEO overconfidence and incentive compensation.

The researchers found that CEO overconfidence increases the proportions of total compensation that comes from both option grants and equity grants, compared to other executives.

Overconfident CEOs receive even greater option and equity intensity in innovative and risky firms.

"Overconfident CEOs are prone to overestimate returns to investments and underestimate risks. They may use extremely positive words in the media or tend to invest more than a typical manager in the industry," Nanda stated.