Executive compensation has inspired heated debate in recent years and the discussion keeps getting more and more indignant. As of April 2007, activist shareholders had submitted nearly three hundred resolutions related to executive compensation, way up from 178 such resolutions submitted in all of 2006. Among the major causes for this upsurge in shareholder concern are many high-profile executive severance packages that the media and shareholders alike have deemed excessive. For example, Robert Nardelli, the former CEO of Home Depot, received $210 million, Disney’s Michael Ovitz received $140 million, Conseco’s Stephen Hilbert received $72 million, and Hewlett-Packard’s Carly Fiorina received $21 million. Even the average CEO severance package—$5.38 million when severance is negotiated prior to employment—raises eyebrows among the most vocal opponents of excessive severance pay.

Deciding how excessive these CEO severance packages actually are can be difficult. Research by Kellogg faculty sheds light on the issue by exploring the underlying business fundamentals of severance pay when it is negotiated prior to employment. It also provides theoretical justification for its existence and enlightens the controversy surrounding the topic. The research, conducted by Kellogg professors Thomas Lys and Tjomme Rusticus as well as Ewa Sletten (PhD 2007, professor at MIT Sloan), provides three reasons why firms grant lucrative severance packages to CEOs within their initial employment contracts: to encourage risk-taking, to provide insurance for an incoming executive, and to compensate CEOs for entering into confidentiality agreements.

CEO Severance as an Incentive for Risk-Taking

CEO severance pay can be viewed as an incentive for CEO risk-taking when it accompanies executive stock option (ESO) packages. As stock volatility increases due to CEO risk-taking, the expected value of both ESOs and severance increases. Naturally, the expected value of ESOs increases when companies’ stocks are more likely to move significantly higher. The expected value of severance pay, on the other hand, increases when companies’ stocks are more likely to fall and CEOs are more likely to lose their positions.

If CEOs were risk-averse and were only offered ESOs as incentives to accept risky projects, executives may prefer to reduce the risk in their own portfolios by attempting to lower the risk associated with their stock-option holdings. If stocks were to lose significant value, not only would their concentrated stock portfolios lose value, but their careers would be in jeopardy. Given that such a negative outcome is a distinct possibility, CEOs might avoid risky projects for the sake of avoiding excessive stock volatility. If, however, risk-averse CEOs were offered downside protection in addition to rewards for exceptional stock performance, the risk associated with their own portfolios would decrease and they would be more likely to accept risky projects. Companies in this case use severance to insure that CEOs accept ambitious projects when they are concerned with their own wealth preservation.

Severance as Insurance

Companies also offer severance pay to incoming CEOs as insurance against a number of scenarios. Volatility of stock returns is positively associated with severance pay—research data indicates that a one standard deviation increase in a firm’s stock volatility results in a 25 percent increase in severance pay. Therefore, severance pay may act as insurance for CEOs working in an industry in which stock returns are volatile. In certain industries, the chance is greater that CEOs may lose their position due to the underperformance of a stock for reasons out of their control.

This insurance effect is also apparent when incoming CEOs are outsiders or when prior CEOs were forced out. In the first case, executives take on the risk that their strategies and work philosophies may clash with that of their employers. Additionally, incoming CEOs have often just left more secure positions to become chief executives. In the second case, the incoming CEO requires compensation as a buffer against a similar fate.

Age also plays a role in severance package negotiations—research indicates that younger incoming CEOs are more likely to get severance agreements. This presumably occurs because younger CEOs face greater future losses than older CEOs should their reputations be tarnished. For example, the reputation of an older CEO might be less susceptible to damage because it is more firmly established. Further, the dollar value of reputation damage for older CEOs may be less than for younger CEOs for the simple reason that they have fewer productive years of work remaining.

In each of these scenarios, incoming CEOs seek protection from the damage that failing to live up to expectations would have upon their future career prospects. Corporations want to recruit the most appropriate talent. The insurance hypothesis also sheds light on some of the often misunderstood “perks” of severance packages, such as legal and outplacement services, secretarial services, and tech support. In all cases, these services are in place to help the out-of-work CEO find a job upon dismissal.

CEO Severance as Compensation for Confidentiality Requirements

Research also suggests that companies offer incoming CEOs a greater amount of ex-ante severance pay when requesting a confidentiality agreement. In the case of job termination, CEOs suffer costs due to an inability to fully utilize their human and intellectual capital. Firms, of course, want to protect their business interests by insisting on CEO confidentiality and are willing to compensate CEOs in exchange for their own future security.

Severance in the Public Sphere: The Case of Carly Fiorina

The case of former Hewlett-Packard CEO Carly Fiorina provides an illuminating example of the motivations behind CEO severance agreements. Hewlett-Packard, the computer and printer giant, hired Fiorina in 1999 to revitalize the company. The media and HP’s executive board believed that her experience at Lucent would help her transform HP from a conservative, behind-the-times company into a technology innovator. Like half of the new CEOs studied by Lys, Rusticus, and Sletten, Fiorina negotiated a severance package prior to employment.

Fiorina’s severance package can be understood as an incentive to promote risk-taking, given her mandate to transform HP’s close-knit and conservative culture. As the first outside CEO hired at HP, the risk of her failing to assimilate to HP’s culture was high. At 44 years of age, Mrs. Fiorina was also quite young when she became HP’s CEO.

Upon her dismissal from HP, Fiorina received severance of $21.4 million in cash and $50,000 for financial counseling, legal services, outplacement services, and other benefits. Announcement of her severance package led to consternation among shareholders and business media. However, given the underlying conditions of her hiring, you would expect Fiorina’s severance agreement to have been more lucrative than an average severance agreement. The extent to which her package was excessive, however, is a slightly different question.


Despite popular conceptions, CEO severance payments tend to reflect underlying business fundamentals or uncertainties present during the hiring of a new CEO. Such agreements are negotiated to promote CEO actions that are in the best interest of the firm and to recruit executives who are most capable of achieving desired results.

Poor corporate governance may play a role in the granting of some dubious severance packages. However, as pay-disclosure rules mandated by the SEC have become stricter and the public has become more aware of the extent of executive compensation, corporate boards have begun to offer less extravagant pay packages. Within this environment, perquisites have disappeared quickly while severance pay appears to have remained, suggesting that there is a place for it within an executive’s compensation agreement.

In addition, research suggests little association between the presence of ex-ante severance agreements and yardsticks commonly used to measure executive board strength, such as the fraction of outside directors, or whether an executive board staggers the elections of its board members. Furthermore, the reasons why a potential CEO negotiating from a strong position would focus negotiations upon severance pay instead of more immediate compensation are unclear. Rather, the research supports three motivations behind executive severance agreements: to encourage risk-taking, to provide job insurance, and to compensate CEOs in the instance of confidentiality requirements. While the question of whether or not CEO severance packages are excessive will certainly remain controversial, it is clear that the existence of substantial CEO severance packages has a theoretical foundation.