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

72 Pages Posted: 29 Apr 2020 Last revised: 30 Mar 2022

See all articles by Oscar Timmermans

Oscar Timmermans

London School of Economics & Political Science (LSE)

Date Written: March 29, 2022

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

Suggested Citation

Timmermans, Oscar, What are the Risk-Taking Properties of Long-Term Incentive Plans Based on Relative Performance? (March 29, 2022). Available at SSRN: https://ssrn.com/abstract=3570875 or http://dx.doi.org/10.2139/ssrn.3570875

Oscar Timmermans (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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