Review of Accounting Studies, 4, 45–60 (1999)
1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Managing Employee Compensation Risk
PAUL E. FISCHER
Suite 2400 Steinberg DietrichHall, The Wharton School, University of Pennsylvania, Philadelphia, PA19104-6365
Abstract. We analyze a principal-agent model in which the principal (e.g., shareholders) and the agent (e.g., an
employee) can personally trade securities tied to the outcome of an uncontrollable event affecting output. The
model is employed to address two questions. First, under what conditions does compensation risk management at
the individual level substitute for compensation risk management at the ﬁrm level? Second, if compensation risk
management at the ﬁrm level is optimal, how should the compensation risk be managed?
Performance measures that are utilized in incentive contracts for employees, such as stock
price or accounting earnings, are often affected by events that are beyond the control of the
employees. Standard agency theory suggests that incentive contacts can be improved if they
appropriately adjust for events that are beyond the control of the agent (i.e., employee).
Consistent with the observation, researchers havearguedthat compensationmay beadjusted
for uncontrollable events by: repricing stock options after uncontrollable shocks to the
stock price (Saly (1994)); using relative performance measures to ﬁlter out uncontrollable
industry wide shocks (Antle and Smith (1986)); or hedging performance measures used in
compensation contracts to shield them from uncontrollable events (Smith and Stultz (1985),
Campbell and Kracaw (1987), and Kim and Titman (1996)).
A criticism of this reasoning is that it relies on the assumption that employees do not
have access to markets in which uncontrollable risks can be managed (see Smith and Stultz
(1985), Campbell and Kracaw (1987), Froot, Scharfstein, and Stein (1993)). If employees
do have access to such markets, they can adjust their exposure to uncontrollable risks by
an appropriate personal risk management strategy. In other words, an employee’s personal
risk management strategy can substitute for compensation risk management at the level
of the ﬁrm. This criticism, assuming it is valid, has the direct implication that managing
employee exposure to uncontrollable risks at the ﬁrm level (i.e., through compensation) is
of no value.
One possible response to this criticism is that, in the real world, employees do not have
access to markets where uncontrollable risks can be managed (e.g., an individual cannot
easily enter into a swap agreement intermediated by a bank). Consequently, it is natural to
assume that employees cannot manage uncontrollable risks on their own account. While
it is true that employees do not have the same access to hedging instruments as a ﬁrm,
it is equally true that individuals do have access to markets where they can hedge risks
with low transaction costs. First, many individuals have wealth tied up in mutual funds
that are associated with pension plans, individual retirement accounts, and educational
savings accounts. In these cases, an individual can use fund choices to manage exposure
to uncontrollable macroeconomic shocks. For instance, an individual whose ﬁrm (i.e.,