Risk Premia in Executive Compensation: A Life-Cycle Perspective

How much of the rise in CEO pay can be explained by the increased risk that CEOs are exposed to? This paper employs a life-cycle model of consumption and saving to answer this question, and, more broadly, to study the risk-reward tradeoff in executive compensation. The model incorporates the main types of risk that executives of public corporations face: optionand stock-based pay, pay-performance sensitivity, dismissal risk, and stock return volatility. I use the model to compute risk premia in pay levels, and analyze how well they explain the observed variation in CEO pay. A calibration to a large panel of CEOs shows that, for realistic degrees of risk aversion, risk premia explain about 20 percent of the variation in CEO pay, both in the cross-section and the time-series. The model captures the higher moments of the cross-sectional pay distribution particularly well. ∗University of California Berkeley, University of Zurich and Swiss Finance Institute (SFI). Address: 508-1 Evans Hall #3880, Berkeley, CA 94720-3880. Email: [email protected]. I am especially grateful to Ulrike Malmendier and Stefano DellaVigna for their support, guidance, and the many valuable comments and suggestions. I thank Dirk Jenter and Fadi Kanaan for generously sharing their data. I thank Michel Habib, Yuriy Gorodnichenko, Pat Kline, Martin Lettau, David Sraer and Adam Szeidl for helpful discussions and participants at the Berkeley Financial Economics Seminar and Macro Lunch for comments. I am also grateful to Sebastian Stumpner and Johannes Wieland for discussing many details of the paper. Financial support from the Swiss Finance Institute and the University of Zurich is gratefully acknowledged.