Labor Unemployment Risk and CEO Incentive Compensation

Abstract:
We investigate the impact of workers’ exposure to unemployment risk on the design of CEO incentive compensation. Through its impact on risk-taking activities, option-based compensation is likely to also influence unemployment risk which is internalized by the firm. 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 provide managers with more stock option grants that result in more convexity payoffs. This behavior is consistent with the view that CEO’s risk-taking incentives are amplified by the board to take advantage of lower costs associated with unemployment risk. The increase in convexity payoff structures is stronger when CEO wealth is tied closely to firm performance, more pronounced in labor-intensive industries, and attenuated by the strength of unionization. The increase in the convexity payoff from option-based compensation induces managers to increase the riskiness of investments and leverage. 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.