Wealth Shocks and Executive Compensation: Evidence from CEO Divorce

To empirically test the impact of CEOs' outside wealth on their compensation, I use spousal divorce as a proxy for an exogenous, negative shock to a CEO's outside wealth. I hypothesize that this shock decreases a CEO's risk tolerance. I also expect that the board of directors responds to this decrease by raising the CEO's cash compensation and by increasing the sensitivity of the CEO's compensation to changes in firm value. I find that cash bonuses, restricted stock grants, and option grants increase following a CEO's divorce, consistent with boards reacting to changes in CEOs' outside wealth and risk incentives. I also find that firms' total risk and idiosyncratic risk significantly drop during the year of a CEO's divorce, consistent with a drop in the CEO's risk tolerance. Overconfident CEOs, who are more risk tolerant, do not receive the same increases in compensation following divorce. I find little support for the relation between divorce and compensation being endogenously determined by performance or by poor corporate governance. Overall, the results support predictions that the board of directors takes the CEO's wealth into account when setting compensation and that outside wealth impacts the CEO's risk preferences