February 7, 2013
How big is that parachute?
Waterloo researchers find connection between severance plans and CEO’s risky behaviour.
They run billion-dollar companies, provide income for thousands of families and make decisions that send economies soaring to the clouds, or diving to the ground.
Top chief executives officers (CEOs) command big pay cheques for shouldering enormous responsibilities. However, since the credit crash of 2008, their decisions have come under close study by aggrieved shareholders and curious academics.
“I’m interested in human behavior and how incentives drive human behavior,” says Kareen Brown, assistant professor at the University of Waterloo’s School of Accounting and Finance.
Brown and two colleagues -- Ranjini Jha, associate professor at the school, and Parunchana Pacharn, associate professor in the Faculty of Business at Brock University, St. Catharines, Ont. -- are studying severances for top executives in American banks.
“Does the severance pay that CEOs in the financial services sector receive encourage risk-taking? asks Brown, describing the research. “And does it go even further, into taking excessive risks that could lead to diminished returns for the shareholders?”
The findings so far seem to suggest so.
Brown, Jha and Pacharn examined severance contracts between 2002 and 2010. They found that few banks initially used severance agreements to attract top CEOs; by 2006, that had changed.
Severance pay builds security for executives. If they have something to fall back on, says Brown, executives may be more inclined to move their companies into riskier ventures and products that deliver higher rates of return.
Brown and her colleagues looked at specific indicators such as the likelihood of default, and impaired loans -- and found a positive association between risk-taking and severance.
“We found that risk certainly increased because of severance pay,” says Brown. “But we also found excessive risk-taking because of severance pay.”
“We’re seeing a reduction in severance plans,’’ Brown says. “This effect on the firms, we still have to study. It’s anybody’s guess how that’s going to affect the quality of the executives that a firm can attract. How that can affect performance, we don’t know.”