Do executive compensation contracts align managers’ and shareholders’ interests, and if so, how? Scholars traditionally assume that compensation contracts incentivize managers to act in shareholders’ best interests, but more recent studies suggest that managerial and institutional factors also affect executive pay. HKUST’s Chao Tang and colleagues shed light on this puzzle by revealing how compensation contracts respond to shocks that affect what managers and shareholders want from their company.

“An important implication of the incentive-alignment hypothesis is that optimal compensation policies should respond to the dynamic preferences of shareholders and managers,” the researchers say. For instance, if the two parties have increasingly divergent incentives to take risks, the board should adjust executive compensation to realign their incentives. However, empirically examining this proposition can be challenging, given the difficulty of measuring managerial and shareholder preferences.

Rising to this challenge, the authors use two empirical settings to determine how shocks that affect both managers’ and shareholders’ interests influence the design of compensation contracts. First, they use changes in local real estate prices as a shock to test their theory that managers’ and shareholders’ risk preferences are affected differently by variations in firms’ asset value.

They find that a negative change in real estate value “leads to an increase in risk-taking incentives in executive compensation packages,” which they attribute to an increasing gap between managers’ and shareholders’ risk preferences. This assumption is corroborated in their second empirical setting, based on severe natural disaster shocks. “Firms negatively impacted by disasters provide more risk-taking incentives in their managerial compensation,” they observe.

Together, these findings confirm the incentive-alignment hypothesis and provide novel evidence of how external shocks that differentially affect the incentives of shareholders and managers influence compensation design. Boards can use these insights to design executive pay that adjusts to changing business conditions, keeping managers’ and shareholders’ interests aligned even during unexpected circumstances.