Each year, a significant number of publicly listed companies in the U.S. face the departure of their CEOs. While these transitions are inevitable, they represent critical moments in a company’s lifecycle, often leading to long-lasting financial and strategic problems when poorly managed. Yet, many companies are ill-prepared for these moments. In a new paper, we explore why and estimate the costs and benefits of CEO succession plans while quantifying their impact on shareholder value.

CEO turnover can be disruptive as well as costly. Firms caught off guard may spend extended periods grappling with a CEO-succession crisis, attempting to manage the fallout while under pressure to select a replacement. This urgency often results in poor decisions, such as appointing an unsuitable successor. Compounding the challenge is the difficulty of predicting CEO departures, which can arise from a variety of reasons. CEOs may be dismissed for underperformance or scandals, resign for personal or professional reasons, or step down unexpectedly due to health issues or other unforeseen circumstances.

Given the importance of CEO succession, one might expect boards to plan for it. However, evidence from SEC filings reveals that many firms do not. Surveys of board directors further indicate that boards not only dedicate little time to discussing CEO succession but are also often unable to promptly name a successor when a CEO steps down. Although there has been some progress, with more firms disclosing that they have outlined CEO succession plans, many companies remain unprepared, despite growing pressure from consulting groups, proxy advisers, and the SEC, which in 2009 mandated the disclosure of succession plans in proxy filings and encouraged boards to reevaluate their policies.

In our paper, we begin by providing evidence of the benefits of CEO succession plans and their impact on firm performance using data on firm profitability, CEO careers, and plan adoption. We find that firms with such plans perform better than firms without them around the time their respective CEOs step down. Specifically, the profits of firms with succession plans drop less during this period. Further analysis reveals that firm performance depends on whether the successor is an internal or external candidate. Firms that appoint an internal candidate perform better than those selecting an external candidate during the turnover year. These findings highlight that CEO succession plans reduce shareholders’ financial losses during CEO transitions, with the effect being most pronounced when the successor is an insider. Plans create two advantages: They enhance board readiness to replace underperforming CEOs, and they reduce the costs of disruption losses when CEOs depart. While the first advantage applies regardless of whether the new CEO is internal, the second is especially pronounced when insiders are promoted because they provide continuity and stability.

We next examine the performance of firms led by different types of CEOs during the years of CEO dismissals. We find that firms led by CEOs appointed internally under a plan have a higher forced CEO turnover-performance sensitivity – meaning they are more likely to fire a CEO based on performance –  than do firms led by CEOs appointed without a plan or firms led by externally hired CEOs appointed under a plan. This suggests that CEO succession plans provide boards with more accurate and comprehensive information about potential internal successors, enabling boards to assess a CEO’s fit more effectively and make quicker decisions about dismissals.

Succession planning often requires  boards to identify and prepare potential candidates early through interviews, mentorship, and training, giving boards deeper insights into the ability and readiness of internal candidates at the start of their tenure. This advantage is unique to internal candidates, as other candidates do not undergo as much scrutiny and preparation. By engaging in succession planning, boards not only improve the quality of information about internally appointed CEOs, but also establish clear benchmarks for evaluating whether hiring an external candidate would be a better choice.

Finally, we analyze firm performance around the adoption of CEO succession plans and find no significant drop in the adoption year or decline in the subsequent years. These patterns indicate that CEO succession plans do not impose substantial financial costs on firms. Considering the previously discussed benefits, we hypothesize that the lack of planning is driven by personal costs to directors rather than financial burdens on firms. Specifically, directors may be reluctant to adopt succession plans due to the considerable time and effort required to identify and develop potential successors. Additionally, succession planning may strain directors’ relationship with a current CEO, who might interpret planning  as a sign of mistrust or increased risk of replacement. This perception could lead to retaliation or tension, discouraging directors from pursuing a formal succession plan.

Building on this evidence, we develop a model in which a board of directors learns over time about the CEO’s ability to lead the firm and makes decisions regarding whether to fire the CEO, adopt a CEO succession plan, and use the plan in succession decisions if one has been adopted. The model is informed by the findings discussed earlier, as we assume that succession plans offer the benefits of reducing CEO turnover costs and providing a more accurate assessment of potential successors. In the model, a succession plan allows the board to gather information about the firm’s most promising internal candidates. This information enables the board to make well-informed decisions about whether to promote an internal candidate or hire an external one if no internal candidate is deemed suitable. Succession planning helps the board avoid promoting internal candidates who are a poor fit for the firm’s needs. However, if the board chooses to hire an external candidate, the plan’s strategies to mitigate the disruption costs of turnovers become ineffective, and the firm bears the full turnover costs.

The model accounts for the potential misalignment of incentives between the board and shareholders regarding the adoption of a CEO succession plan. While directors benefit financially from the plan’s positive impact on firm performance, they bear personal costs associated with its adoption. These costs include the effort required to implement the plan and the potential for strained relations with the current CEO. This misalignment can discourage directors from adopting a succession plan despite its clear advantages.

Our model estimates reveal that CEO succession plans offer significant benefits. Using a CEO succession plan reduces CEO turnover losses by approximately one-third and improves the accuracy of assessments for internal successor candidates by 25 percent compared with other types of candidates. Despite these advantages, directors incur substantial personal costs from adopting such plans.

To explain the low adoption rate, our findings suggest that boards perceive the cost of adopting a plan as equivalent to 4 percent of the firm’s assets. When analyzing various subsamples, we find that larger firms, those with more directors, and those with high levels of institutional ownership experience fewer agency conflicts related to succession planning and manage succession more effectively. Interestingly, a high number of independent directors does not appear to enhance the succession planning process. Additionally, the SEC’s 2009 mandate motivated boards to adopt CEO succession plans, improve CEO selection, and facilitate smoother leadership transitions. Finally, our analysis indicates that a reform mandating CEO succession plans would increase shareholder value by 3.1 percent.

This post comes to us from Francesco Celentano at the University of Lausanne and Swiss Finance Institute and Antonio Mello at the University of Wisconsin – Madison. It is based on their recent paper, “Why Do Firms Often Not Have a CEO Succession Plan?” available here.