David F. Larcker and Brian Tayan
Few boards look at how the CEO’s total wealth invested in the company changes as stock
prices fluctuate. They could—and they should.
Does your CEO
compensation plan
provide the
right incentives?
Boards, shareholders, and journal-
ists often look at a chief executive’s
annual compensation plan to
determine whether the company is
offering the right incentives
to increase shareholder value. But
few consider another key question:
how does the compensation that
the CEO has already received over
the years in the form of stock and
stock options influence managerial
decision making? Our research
shows that for most CEOs in the
United States, accumulated wealth
effects are likely to swamp those
of year-to-year compensation—merit-
ing serious attention when boards
evaluate how risk structures and
incentives of executive pay packages
align with the company’s strategy.
Wealth effects
Since 2006, a wider array of data
on executive holdings of stock
and options has become available
in proxy statements filed with
the US Securities and Exchange
Commission. There is now enough
of it to permit serious research.
We began by taking the median
total annual compensation of chief
executives and comparing it
with their median total accumulated
wealth.1 For those at the largest
20 percent of publicly traded
companies, median accumulated
wealth was nine times CEO median
compensation. We also plotted
the percentage change in CEO
wealth against percentage changes
in stock price and found that
a 50 percent increase in stock price
would translate, at the median, to
an expected wealth gain of six times
annual compensation. For smaller
companies, total compensation lev-
els are lower. The ratios of accu-
mulated CEO wealth to income, as
well as those of wealth increases
to income resulting from significant
stock price gains, are also some-
what lower.2
A P R I L 2 0 1 2
2
These results, which in large part
reflect the leverage provided by stock
option grants that are part of pay
packages at many companies,
highlight the substantial monetary
incentives offered for CEOs to
make strategic and investment deci-
sions that increase shareholder
value. Our data further indicate that
wealth effects—and thus the lev-
els of risk that CEOs are encouraged
to take—vary widely, even among
direct competitors. It is not always
clear if this is intentional or simply
the inadvertent, cumulative impact
of grants made year after year at
varying price levels that are either
higher or lower than today’s
price—which could leave the chief
executive with a portfolio of shares
and options whose payoff function
is quite different from what the
board originally intended.
Comparing pay structures
via ‘convexity’
One practical way of making this
assessment is to plot changes
in CEO wealth against changes in
the company share price and
observe the shape (or “convexity”)
of this payoff curve. If the CEO’s
portfolio contains only shares, it will
tend to rise and fall one-for-one
with a change in stock price. We refer
to this as “low convexity.” If, how-
ever, the CEO’s portfolio contains
a large number of stock options,
and especially multiple tranches of
out-of-the-money stock options,
the payoff curve can become quite
steep (high convexity). Convex
payoff structures such as these pro-
vide more financial incentives for
CEOs to take on promising—albeit
risky—investments because
the CEO stands to earn very large
rewards if successful. By performing
this analysis, the board can bench-
mark the CEO’s payoff function
against those of direct competitors to
determine whether the incentive
structures are comparable to other
leaders in the industry.
Consider the experiences of two
CEOs from competing firms in the
fashion retailing industry (Exhibit 1).
Whereas a 100 percent increase
in stock price would lead to a
102 percent increase in wealth for the
CEO of one company, it would
lead to a 190 percent increase in
wealth for the second company—
a much more convex payoff as
a result of a richer mix of options.
Compensation at the latter com-
pany may thus encourage greater
risk taking. It might be the case
Our data further indicate
that wealth effects—
and thus the levels of
risk that CEOs are
encouraged to take—
vary widely, even among
direct competitors.
3
that these are both appropriate
arrangements, because the
two firms face different strategic
opportunities and challenges. It
could also be the unintended
result of option grant timing and
market performance. Or it
might be the case that the market
opportunities for the companies
are similar and the boards of one or
both haven’t thought deeply about
whether incentives are appropriate.
Similarly, we found that the CEO
of one regulated public utility
has convexity in his compensation
of 1.00 (a 100 percent increase
in stock price leads to a 100 percent
increase in wealth), while the CEO
of another public utility has convexity
of 1.51. Here, too, having a clear
picture of the two compensation
contours can help board members
decide on whether risk levels are
appropriate for regulated utilities.
The shape—or ‘convexity’—of a CEO’s payoff curve provides
a benchmark to determine whether the incentive
structures are comparable to those of other industry leaders.
Q2 2012
Governance
Exhibit 1 of 2
The shape—or ‘convexity’—of a CEO’s payoff curve provides
a benchmark to determine whether the incentive structures
are comparable to those of other industry leaders.
Increase in CEO’s
wealth from
100% increase in
stock price
Example of 2 fashion retailers
Change in expected value of CEO’s stock and option
portfolio caused by change in stock price, %
Retailer B
Retailer A
−50
−100
−50−100 100500
100
150
200
50
0
Change in stock price, %
Curve is convex:
portfolio contains
a large number of
stock options
Curve is not
convex: portfolio
contains fewer
stock options
102%
190%
Source: Calculations by David F. Larcker and Brian Tayan, based on compensation data provided in each company’s 2011 Form DEF-14A
Exhibit 1
4
A significant share of compensation in stock options
causes a CEO’s payout to rise dramatically with a rise in
stock price volatility.
Q2 2012
Governance
Exhibit 2 of 2
A significant share of compensation in stock options
causes a CEO’s payout to rise dramatically with a rise in
stock price volatility.
−10
−20
−30
−40
−50
−50−100 100500
20
30
40
50
10
0
Change in stock price volatility, %
0 = current expected net
present value at company’s
current volatility
Example of 2 pharmaceutical companies
Change in expected value of CEO’s stock and option portfolio
caused by change in stock price volatility, %
Source: Calculations by David F. Larcker and Brian Tayan, based on compensation data provided in each company’s 2011 Form DEF-14A
Pharma company B
Pharma company A
Volatility as a window on risk
We can take the analysis one
step further and plot the change in
expected CEO wealth against
changes in stock price volatility. This
additional detail can paint a stark
picture of the degree to which boards
are encouraging risk taking.
The foundation for this analysis
is the incentives associated
with stock options and grants: If a
CEO’s investment portfolio is
heavily weighted toward options, he
or she is motivated to take on
risky investments because the
present value of the options
package increases as volatility rises
in step with a more ambitious
and potentially uncertain strategy. If,
on the other hand, the investment
portfolio is composed entirely
of stock, the CEO is not rewarded
for volatility, creating an incentive
to take on safer projects with lower
risk and return.
This dynamic is illustrated by two
pharmaceutical companies shown
in Exhibit 2. The CEO of company
Exhibit 2
5
A holds only direct stock investments
and restricted shares, so the exec-
utive’s payout function is essentially
a flat line and is unaffected by a
volatile stock price. The CEO of com-
pany B, by contrast, receives a
significant share of compensation
in stock options, so the exec-
utive’s payout rises dramatically with
greater volatility, as shown by the
upwardly sloping line.
Which is the better approach? The
answer will depend on whether
the success of the company requires
innovation and risky investment or
whether it requires the steady devel-
opment of existing products. In
the pharmaceutical industry, it is not
hard to imagine that the board
should encourage at least some level
of risk. Risky projects that fail
are sure to destroy value, but failure
to innovate at all is also sure to
destroy value.
Evaluating your CEO’s payoff
structure
Since this analysis is relatively new,
and wealth effects aren’t routinely
calculated and reported, we suggest
boards do some benchmarking
against peers to see if it raises ques-
tions about the financial incentives
they have created for their CEO.
Is risk in line with industry peers, and,
more importantly, is it in line with
the company’s strategic objectives?
Have changes in the stock market
changed the convexity of the CEO’s
reward curve in a way that encour-
ages excessive risk? If so, should the
board change the mix of future
annual pay grants to get the curve
back in line with objectives? Should
it reprice existing options to reduce
convexity? If the CEO wants to
sell or hedge some of his or her
personal portfolio in order to reduce
personal-investment risk, how
will this change the incentives
to perform?
Boards should also be aware of how
the effects of tenure may misalign
CEO incentives and strategy over the
longer term. For long-standing
CEOs, convexity will often decline
as options vest and wealth in the
company shifts primarily to stock.
The board in this case may want
to amplify convexity to discourage
risk aversion. In a less frequent
occurrence, the time effects may
actually increase convexity,
when, for example, a company is
recovering from a long-term
decline in share price and an exec-
utive retains a substantial num-
ber of unexercised options that had
been deeply out of the money.
Here, appropriate action to dampen
convexity may be required.
Finally, it is useful in another way for
the board to understand the dollar
amount that the CEO can earn if “all
the stars align” for the firm and its
stock price rises sharply. Boards are
sometimes faced with the problem
of what to say to activist shareholders
and media when the CEO receives
very large payouts. The wrong
answer is, “We never looked at that,
because we did not think it would
happen.” Many boards will likely find
that the payout amounts for various
levels of stock price targets are
6
much different than they expected,
often encouraging too much or too
little risk. That might also be true for
other senior executives, and boards
could do well, as a second step, to
examine their payoff structures too.
David Larcker is the James Irvin
Miller Professor of Accounting
at Stanford University, senior faculty
member at Stanford’s Rock Center
for Corporate Governance, and
director of Stanford’s Corporate
Governance Research Program,
where Brian Tayan is a researcher.
They are coauthors of Corporate
Governance Matters: A Closer Look
at Organizational Choices and Their
Consequences (FT Press, April 2011).
Copyright © 2012 McKinsey & Company.
All rights reserved. We welcome your
comments on this article. Please send them
to quarterly_comments@mckinsey.com.
1 We define CEO wealth as the total value
and the expected value of stock options that
an executive continues to hold at a company.
We exclude personal wealth outside company
stock (this is not typically disclosed). Stock
options are valued using the Black–Scholes
pricing model, with the remaining term
of the option reduced by 30 percent to com-
pensate for potential early exercise or
termination and volatility based on actual
results from the previous year.
2 For additional discussion of compensation
and wealth effects, see David F. Larcker and
Brian Tayan, Sensitivity of CEO Wealth to
Stock Price: A New Tool for Assessing Pay for
Performance, Stanford Graduate School of
Business, Closer Look Series Case No. CGRP-
10, September 2010.