Creating More Tail Risk in the Incentive Compensation Plan as a Risk Mitigation Strategy

As the recent financial crisis has witnessed, the current incentive compensation plans for company executives have not done an effective job in curtailing the executives’ excessive risk taking behavior and encouraging them to take appropriate risk management actions in their strategic decision makings. This outcome could be largely attributed to the current compensation practice in which the executives do not participate sufficiently with negative performance of the company. This is a classic principal-agency problem, and this issue can be in part addressed by designing the compensation plan such that the executives’ pay suffers more severely with poor performance of the company. With this design of the incentive compensation plans, the executives will have incentives to consider downside risk more seriously and establish appropriate risk management processes.