Why CEOs Nearing Retirement are Averse to Risk
•The reluctance of CEOs approaching retirement to engage in short-term risk-taking can be detrimental to company growth.
•This aversion to risk is based on two concerns: (1) CEOs are not keen to taking risks that may taint their reputations in their final years; and (2) they want to preserve their assets (which are in part indexed to the company’s stock value) from any loss in value.
•The remuneration model that indexes part of the CEO’s compensation upon retirement to company stock value can be damaging for the company.
The rising number of press articles attributing the success and failure of major firms to their CEOs led Matta and Beamish to study the CEOs role in strategic decision-making. How did CEOs influence their company’s long-term investments? The two researchers provide an initial answer to this question by examining the risk-taking behaviour of CEOs nearing retirement in the context of international acquisitions.
WHY WAS INTERNATIONAL ACQUISITIONS CHOSEN AS THE CONTEXT FOR THE STUDY?
Elie Matta and Paul W. Beamish studied the international acquisitions made by 293 major American firms between 1995 and 1999. By studying acquisitions (as opposed to R&D investments, for instance, which are part of a more long-term strategy —less variable and more visible), the researchers were able to focus on short-term decisions that directly involved the CEO. The empirical study of international acquisitions made in the second half of the 1990s, incurring significant up-front costs,, was particularly interesting as it revived the notion of managerial risk-taking. Elie Matta points out, however, that although the study uses acquisitions for its context, the theoretical arguments of the study can be applied to risk-taking in general.
THE IMPACT OF CAREER HORIZON ON RISKTAKING
The two researchers’ observations show that CEOs with shorter career horizons are less likely to engage in international acquisitions. Elie Matta explains that CEOs approaching retirement avoid risky strategic choices, as returns often cannot be predicted. The application of the agency theory, which suggests that attempting to align the CEO’s (agent) decision horizon with shareholders’ (principals) interests by enlisting the former to commit to ensuring the company’s long-term financial performance, does not produce the desired results as the CEO nears retirement. By integrating behavioural arguments (prospect theory), the researchers suggest that the CEO’s aversion to loss (heightened close to retirement) encourages him to make decisions that maintain stability in the medium term, whereas shareholders would prefer decisions aimed at ensuring the company’s future growth. This explains the gap between CEOs’ short-term reasoning as they near retirement (and who therefore lose interest in the company’s future results) and the shareholders’ long-term interests.
THE REASONS FOR CEOS’ RISK AVERSION AS THEY APPROACH RETIREMENT
Elie Matta and PaulW. Beamish suggest two reasons for this phenomenon:
• The desire to maintain an image: CEOs are particularly concerned about preserving a legacy of success. The last years of a CEO’s career are crucial to his image: it is difficult to reverse a performance downfall in the last three years of a career. As people are more inclined to remember recent and not past results, such a failure could ruin an otherwise successful career. The CEO’s aversion to risk therefore increases when he knows that they will soon be leaving the company.
• The desire to maintain their wealth: CEOs accumulate various forms of compensation, combining fixed salary with variable payments. Payment may also take the form of stock options or shares. A CEO's retirement package (which is accumulated wealth) is directly linked to their shares in the company's stock, as retirement presents an opportunity to “cash-out.” Thus, there is a close correlation between CEOs with significant levels of accumulated wealth and their desire to maximize the value of personal shares and investments, and hence avoid investments that could result in fluctuations in shares prices just prior to retirement.
A MODEL THAT DAMAGES THE COMPANY’S LONG-TERM GROWTH
The study’s results raise an additional question: can CEOs' aversion to short-term risk when approaching retirement be detrimental to the company's growth? The authors note that the average age of newly appointed CEOs is 58, which is only seven to twelve years before the age of retirement. Risky strategic decisions therefore depend on the compensation structure, adjusted in accordance with the career horizon. Since a company's long-term growth is directly linked to its capacity to make risky investments, the remuneration model that indexes a large part of the CEO's pay to company stock value can be damaging when a CEO is approaching retirement !
Based on an interview with Elie Matta and his article “The Accentuated CEO Career Horizon Problem: Evidence from International Acquisitions” (Strategic Management Journal , July 2008), co-written with Paul W. Beamish.
FROM THE LAB TO THE WORKPLACE
The CEOsin the study had an average capital of $90million in shares and stock optionsjust before they retired. The study highlights the perversity of a compensationsystem that exposes CEOs to too much risk, thus not impeding them from consideringtheir company's long-term growth interests, in the last years of their career. Mattaand Beamish stress the need to review compensation programs in largecorporations so that the CEO's status or the competition’s practices are ofless importance. They recommend a more personalized method of compensationbased on the CEO’s career horizon and their current number of shares in companystock.
To study managerial risk-taking, the researchers focused on international acquisitions made between 1995 and 1999 by 293 US-incorporated firms. The firms were chosen according to three criteria: 1) the availability of internationalization data, 2) the availability of compensation data on its CEO and 3) the presence of a sole CEO throughout the study period. Data sources included: S&P’s COMPUSTAT, US Securities and Exchange Commission’s (SEC) EDGAR database, and Thomson Financial’s SDC Platinum Mergers and Acquisitions database.