Labor Unemployment Risk and CEO Incentive Compensation

Abstract

In this paper, we investigate the impact of workers’ unemployment risk, a salient attribute of labor market frictions, on the design of CEO incentive compensation. Exploiting state-level changes in unemployment insurance benefits as a source of variation in the unemployment costs faced by workers, we find that, after unemployment insurance benefits increase, boards adjust the compensation structure and provide managers with more stock option grants that result in more convexity payoffs. Such a change is consistent with the view that CEO’s risk-taking incentives are amplified to take advantage of lower unemployment costs. The increase in convexity payoff structures is more pronounced in labor-intensive industries and industries that have higher layoff propensity, but is significantly attenuated when strong labor unions are present. The results are also stronger when CEO wealth is more closely tied to firm performance. Finally, we show that the increase in convexity payoff from option-based compensation induces firms to undertake more risky investments that deliver improved operating performance after the increase in unemployment insurance benefits. These results suggest that firms respond to unemployment risk by changing their risk taking behavior, and one channel through which they do so is executive compensation.