Working Paper: NBER ID: w15324
Authors: Alex Edmans; Xavier Gabaix; Tomasz Sadzik; Yuliy Sannikov
Abstract: Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. We derive the optimal contract in a setting where the CEO can affect firm value through both productive effort and costly manipulation, and may undo the contract by privately saving. The optimal contract takes a surprisingly simple form, and can be implemented by a "Dynamic Incentive Account." The CEO's expected pay is escrowed into an account, a fraction of which is invested in the firm's stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO's employment and after he quits, to deter short-termist actions before retirement.
Keywords: CEO compensation; dynamic contracts; incentive design; manipulation; private savings
JEL Codes: D2; D3; G34; J3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal contract sensitivity (D86) | deter manipulation before CEO's retirement (G34) |
| CEO's effort (M12) | firm value (G32) |
| manipulation (C78) | effectiveness of contract (K12) |
| sensitivity of contract to current returns (G12) | increase over time (O42) |
| timing of rewards (C41) | CEO's age and urgency of performance (L25) |
| dynamic incentive accounts (DIAs) (F33) | prevent manipulation (C93) |
| traditional compensation structures (J33) | misalignment of incentives (D82) |