Do optimistic executives get paid less?

By Clemens Otto, Professor of Finance - September 14th, 2014
CEO Optimism and Incentive Compensation by Clemens Otto

The pay of senior executives has long been a hot-button issue in management. But, for the first time, an empirical study that measures CEO optimism through option exercise decisions and earnings forecasts shows that boards can exploit the very common human bias of optimism to negotiate lower compensation packages for CEOs.

Clemens Otto ©HEC Paris

Clemens Otto joined HEC Paris in 2012 as professor of finance after obtaining his M.Res and Ph.D in finance from the London Business School. He studied business economics and (...)

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Even the most ordinary person believes they will live longer than average, land a better job and have above average intelligence children, while grossly underestimating their chances of getting divorced, crashing their car or losing their job. This tendency to expect a rosier future than is realistic is a phenomenon known as the optimism bias. It is the most prevalent and persistent psychological bias, cutting across gender, nationality and age. Unsurprisingly, chief executive officers are just as affected by this unconscious prejudice as the rest of us common mortals, but surprisingly, it may actually work against them, and in a rather unexpected domain: their pay slips. In a novel empirical study, HEC Paris researcher Clemens Otto found that optimistic CEOs were actually paid less than their more sensible peers. Considering what an explosive issue top-level executive pay has been in recent years — with the word “exorbitant” often splashed across indignant headlines — this is an interesting finding. Also, economic research may have already documented the impact of the individual characteristics of CEOs on corporate policies and outcomes, but it’s the first time a study empirically examines how CEO beliefs are reflected in pay schemes. 

Optimism about future payoffs

More precisely, the main finding of Clemens Otto's study was that CEOs whose behavior was indicative of optimistic beliefs received smaller stock option grants, fewer bonus payments, and lower total compensation than their peers. Incidentally, these variations could potentially have been observed in rank-and-file employees, except that their contracts tend to be similar across the company, with wages set through union agreements, while compensation packages for CEOs tend to be individually tailored. Regarding senior executives, Clemens Otto says that his findings are consistent with contracting models, where parties reach agreement when they believe they are sufficiently compensated for their efforts: an optimistic CEO overestimates the value of compensation claims that are contingent on successful outcomes — say, an increase in the price of shares in the case of stock options — because he simply overestimates the probability that these outcomes will be realized, i.e.that the value of the shares will go up. 

It’s the first time a study empirically examines how CEO beliefs are reflected in pay schemes. 

Measuring optimism

But how do you determine how unreasonably optimistic an executive is? Firstly, the researcher distinguishes between optimism — “thinking that positive outcomes are more likely than they really are, for example, expecting a 60% chance ofsunshine, rather than a 50% chance as the season would suggest” — and over confidence — “giving too much weight to an information about expected outcomes, while down playing imprecision, for example, overestimating theaccuracy of a weather forecast.” As a first measure of optimism, Clemens Otto constructed a proxy commonly used in this field of research: he looked at CEOs'decisions to exercise stock options. “A rational executive would exercise hisin-the-money-options as early as possible, while an optimist will keep his options” even when the options are already deep in the money, i.e., when it is profitable to exercise the options. His second measure was based on the comparison between the earnings per share (EPS) forecast by the company duringthe CEO's tenure and the earnings actually realized (or the analyst consensus forecast): “very straight forward, since you are looking at expectations about the future, which is really what optimism is all about,” says the researcher. With these two proxies, he was able to identify which CEOs had inflated beliefs for the future of their firms (as well as their own future, happily tied to thecompany’s). 

Neither stupidity nor procrastination

He also controlled for alternative factors that could explain the differences in compensation. After all, perhaps executives whose earnings forecasts were systematically too high were punished for the simple fact of being wrong? But Clemens Otto found that pessimists were rewarded with higher compensation packages. “So it's not a question of stupidity versus smartness or penalizing bad decisions,” he says. What about waiting to exercise options: is it really a gamble on higher earnings, or just procrastination? Again, he found that CEOs were “not too lazy to go to the bank” but were really hoping to cash in, since they carried out other transactions during the same interval of time, and socould very well have exercised their options. Clemens Otto was also able tocontrol for differences in firm characteristics as well as in the CEOs’investment portfolios. With all these robustness tests, his findings remained: optimistic CEOs received lower compensation. Is it unfair that executives withthe most positive outlook get compensated less? “As an economist, it's not forme to say what is fair or unfair,” says Clemens Otto. “But if CEOs accept these contracts, I suppose they are happy with the terms, which are simply consistent with their own beliefs, even if they are overestimating their future earnings.”

Based on an interview with Clemens A. Otto, and the paper "CEO Optimism and Incentive Compensation", published in the Journal of Financial Economics (2014).

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If optimistic CEOs are ready to accept lower compensation packages than their more pessimistic peers, from the point of view of contract theory, it means that principals can exploit the biases of agents by adjusting their contracts. In other words, boards may sometimes take advantage of CEOs, and not the other way around, as the popular press would have it in all their stories of CEOs extracting ridiculously large pays from gullible shareholders. So is it worth it? From the strict point of view of the compensation scheme, optimistic CEOs will indeed come out cheaper. But as Clemens Otto warns, there is a potential cost to hiring “irrational” executives. “The cost of making a poor acquisition, for example, is likely to be much higher than the saving on the executive's compensation,” he says, adding that there is currently no agreement in the academic community on whether or not the net effect on firm value from appointing an optimistic CEO is negative or positive. “What counts is whether the board can intervene and counter bad decisions made by an optimistic CEO,” he concludes.


Clemens Otto used three main data sources for his empirical analysis: information on CEOs' compensation from Execucomp; information on the CEOs' option exercises from the Thompson Reuters insider filings database; and information on earnings per share (EPS) forecasts, analyst estimates and realized earnings from the First Call Historical Database. All data sources covered the U.S. over the years 1996 to 2005. Altogether, he was able to collect 11,477 observations covering 2,559 CEOs and 1,889 firms.