DP11634 | Labor Unemployment Risk and CEO Incentive Compensation

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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 benefits as a source of variation in workers’ unemployment costs, we find that after unemployment insurance benefits become more generous boards increase the CEOs’ convex payoff structure. 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. Changes in the incentive structures are associated with riskier investment and financing strategies and better performance. Results suggest that executive compensation is one mechanism used by boards to internalize labor market frictions in firms’ decisions.