How Paying CEOs in Stock Options Leads to Unsafe Products

A new study questions the long-term effects of a common form of compensation.

Takata executives at a U.S. House Energy and Commerce Subcommittee hearing on airbag recalls on December 3, 2014 (Gary Cameron / Reuters)

As inequality and lagging wages in America take center stage in both economic and political debates, the issue of  whether company executives are overcompensated has again become a talking point—even for the Republican front-runner with a long history in Corporate America. One poll from The Huffington Post shows that 66 percent of Americans feel that executives are paid too much, and this sentiment seems to be universal.

A new study found that consumers have even more reason to be concerned about the structure of executive pay: product safety. In it, a group of researchers at the University of Notre Dame’s Mendoza College of Business took a closer look at how stock options can encourage CEOs to behave recklessly. Paying CEOs with shares of stock is in part an attempt to align the interests of a company’s executives with the that of the company’s. In these types of pay arrangements, CEOs benefit when the company’s stock price ticks up, but doesn’t lose money if the share prices go down. Stock options are a cherished perk: It gives CEOs the right (but not an obligation) to purchase company’s shares at a pre-determined price within a specified period of time.

It turns out this is a recipe for unintended consequences. The researchers looked at the performance of 386 CEOs from 286 FDA-regulated companies between 2004 and 2011 to investigate whether the magnitude of option pay was correlated with the frequency of product recalls. “Our central finding was that abundant stock option pay for CEOs generally increased the incidence of product recalls in the future,” says Adam Wowak, an assistant professor in management and the lead author of the study. “We theorized that higher levels of stock option pay would cause CEOs to favor aggressiveness over thoroughness in their decisions regarding internal company operations, a consequence of which would arguably be a higher likelihood of mistakes in the design, production, or distribution of products.”

One caveat of the study is that the researchers didn’t actually observe the design and production processes inside these companies, but rather just used recall data. That said, the association of options with increased product recalls is consistent with prior research that option-heavy pay packages tend to encourage aggressive risk-taking. And another takeaway of the study is that the association was strongest for the CEOs with the least experience; executives with longer tenures were less susceptible to this effect. (But so were founder-CEOs who, it’s theorized, have stronger incentives to protect their companies.)

Wowak says that many company boards have already started to see these downsides of option pay, and thus it has become less common in the past decade. Instead, companies are turning to stock grants that come with a set of requirements—such as the number of years in tenure and performance targets—in order to balance the reward structure in a way that favors the long run. “The takeaway here is that CEOs can differ in their responses to incentives,” Wowak says.