Preference Dynamics and Risk-Taking Incentives

In the intricate world of corporate governance, the role of executive compensation in aligning the interests of shareholders and managers remains a long-standing question. Classic theories posit that shareholders, as the principals, can design compensation contracts to induce managers, as the agents, to maximize shareholder value. At the same time, recent studies document that other factors, such as rent extraction incentives and institutional changes, also affect the level and structure of executive pay. It remains unclear whether and to what extent executive compensation can effectively align the preferences of shareholders and managers. Our paper, “Preference Dynamics and Risk-Taking Incentives,” forthcoming in the Journal of Accounting and Economics, explores this complex issue and provides new insights into how executive compensation is designed to bridge the gap between the risk preferences of managers and shareholders.

At the core of our paper is the idea that the divergence in risk preferences between managers and shareholders is dynamic, shifting in response to changes in the business environment and external shocks. Consequently, optimal compensation policies should respond to the dynamic preferences of both shareholders and managers. For example, when a firm’s assets decline in value, managers become increasingly concerned about the potential for financial distress, prompting them to favor lower corporate risk. As a result, they may abandon risky but positive net present value projects to mitigate these rising costs. In contrast, shareholders, particularly in leveraged firms, may be inclined toward increased risk-taking as asset values fall. This phenomenon, known as risk-shifting, reflects the reduced downside for shareholders when asset values decline, encouraging them to pursue riskier projects to boost equity value. Thus, examining external shocks that differentially impact shareholders’ and managers’ preferences offers a valuable approach for understanding the incentive alignment role of compensation policies.

We use a parsimonious, illustrative model to convey this economic intuition. In the model, managers bear personal costs associated with financial distress, such as potential damage to their career prospects and reputation. As firms’ asset values decline, managers grow increasingly concerned about the risk of financial distress, leading them to prefer lower corporate risks. Consequently, they may forgo risky yet positive net present value projects to avoid these heightened costs. In contrast, shareholders, particularly in leveraged firms, may exhibit a tendency to increase risk-taking as asset values fall. This phenomenon, known as risk-shifting, occurs because shareholders have less to lose from risk-taking when asset values decline, motivating them to seek greater equity value through riskier projects. Thus, external shocks to firms’ asset value drive the divergence between shareholders’ and managers’ risk-taking incentives. To maintain the alignment of incentives, firms’ compensation policies should dynamically adjust in response to such shocks.

To empirically explore this intuition, we examine two settings that present arguably exogenous shocks to firms’ asset values and business fundamentals. The first setting focuses on changes in the market value of firms’ real estate assets. Using a sample of U.S. public companies with substantial real estate holdings, we apply established methods from the literature to estimate fluctuations in real estate market values. Consistent with prior findings, our descriptive evidence shows that the magnitude of these variations can be meaningful for the firms in our sample. We use two measures to capture risk-taking incentives in executive compensation contracts: the use of option-based pay, which reflects how stock options increase the convexity of the manager’s pay-performance relationship, and the Vega of managers’ equity portfolios, defined as the sensitivity of top executives’ total wealth to changes in stock price volatility. We find a significant negative association between firms’ real estate value and the level of risk-taking incentives in executive pay, consistent with the key prediction of the illustrative model. The results are robust to alternative research design choices, such as using an alternative method for estimating real estate price, applying additional fixed effects, using other measures of risk-taking incentives, adjusting for non-headquarter property ownership, and controlling for firm-specific influence on the local economy.

To further investigate the dynamic preferences mechanism, we analyze firm-level heterogeneities. We construct a composite index capturing managers’ personal costs of distress, using determinants such as tenure length and proxies for external career opportunities. Similarly, we develop an index for shareholders’ risk-shifting incentives, based on blockholding and equity-debt dual ownership. We find that the effect of asset value shocks on risk-taking incentives is more pronounced when managers face higher personal costs of distress and when shareholders have stronger risk-shifting incentives. Additionally, the effect is stronger in firms that are closer to financial distress. These findings align with the predictions of the model and provide further evidence for the hypothesized mechanism.

In the second empirical setting, we use a natural experiment based on severe climate disasters to examine how firms adjust executive pay following significant negative shocks. Prior studies have shown that severe climate events can materially affect business fundamentals and credit risk for the most exposed firms, making this setting suitable for testing our predictions. Using establishment-level data from the U.S. Census Bureau, we identify firms most affected by these shocks and employ a stacked difference-in-differences design to estimate the impact on compensation policies. The analysis shows that companies increase risk-taking incentives in executive compensation after these adverse shocks, consistent with the effects observed in our first empirical setting. Collectively, the results from these two settings enhance the external validity of our findings and help mitigate uncertainties or concerns related to a specific setting.

In summary, our study contributes to the ongoing discussion of how executive compensation aligns the incentives of managers and shareholders, particularly in response to external shocks. We show that compensation structures adapt dynamically to shifts in the economic environment that differently impact managers’ and shareholders’ risk preferences. Through firm-level heterogeneity analyses, we demonstrate that this alignment effect varies by the characteristics of shareholders and managers. Our findings also contribute to the empirical evidence on the risk-shifting hypothesis, suggesting that compensation contracts may act as a transmission mechanism through which changes in risk-taking incentives are translated into firm policy adjustments.