CEO Incentives and Firm Productivity

Abstract

This paper investigates the relationship between firm productivity and CEO performance incentives in a sample of 917 U.S. manufacturing firms during the period 1992-2003. We first find that CEO equity ownership enhances firm productivity and that firm productivity enhances corporate financial performance. We then find that the relationship between CEO performance incentives and productivity is quite complex. There is an inverse U-shaped relationship between productivity and the sensitivity of CEO wealth to share value (delta), which suggests that the high CEO portfolio risk associated with high delta discourages CEOs from undertaking risky positive-NPV, productivity-enhancing projects. We also find that greater sensitivity of CEO option wealth to stock return volatility (vega) generally increases firm productivity, consistent with stock option grants making CEOs less concerned with risk due to the down-side protection it offers. However, for a range of delta values, higher vega may actually reduce productivity, a result that has not been previously documented empirically. This suggests that stock options may not always achieve their intended effect of making CEOs less risk-averse. These results highlight the importance of careful structuring of CEO compensation contracts. Encouragingly, we find that CEO performance incentives positively impact productivity for the vast majority of the firms in our sample.