Which of the following statements regarding compensation policies is FALSE?

Question

BlackTom AI · Accepted Answer

Increasing pay-for-performance sensitivity increases the variability of a manager’s pay rather than reducing it. If compensation is modeled as Pay = a + b·P (where P is firm performance and b is pay-for-performance sensitivity), then Var(Pay) = b^2·Var(P). Raising b multiplies the variance of pay, so higher sensitivity increases pay volatility and therefore the manager’s risk exposure (especially for risk-averse managers). Agency theory and empirical evidence show that stronger pay-for-performance typically raises the manager’s wealth sensitivity to firm outcomes, not lowers risk.

Step-by-step reasoning and relevant concepts:
1. Pay-for-performance sensitivity: the marginal change in pay with respect to performance (b in the simple linear model). It aligns incentives but changes risk characteristics of pay.
2. Variance relationship: Var(Pay) = b^2·Var(P). Increasing b increases Var(Pay) proportionally to b^2, so pay becomes more uncertain.
3. Risk-aversion and diversification: managers often hold human capital and concentrated equity exposure to the firm; increasing pay volatility raises total risk, which is undesirable for risk-averse managers unless compensated by higher expected pay.
4. Agency alignment: stock and option grants align managers’ incentives with shareholders because they increase the payoff from higher stock prices (true statement). Granting equity-like compensation effectively gives managers a stake in residual firm value, approximating ownership (true). During the 1990s, many firms increased equity-based compensation (stock and stock options) for executives—this historical trend is accurate.

Why the first option is false and the others are correct:
- First option (FALSE): claims increased sensitivity reduces managers’ risk—contradicted by Var(Pay)=b^2·Var(P), so risk rises.
- Second option: true—equity compensation directly links manager wealth to stock price.
- Third option: true—performance-tied pay gives managers partial ownership incentives.
- Fourth option: true—historically firms in the 1990s expanded stock/option grants.

Conclusion: The false statement is "Increasing the pay-for-performance sensitivity comes with the added benefit of reducing managers' risk." This matches the provided answer.

Which of the following statements regarding compensation policies is FALSE?单项选择题

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