Dynamic Contract and Discretionary Termination Policy Under Loss Aversion

Abstract

We explore how the timings of compensation payment and contract termination are jointly and optimally determined in a continuous-time principal—agent model under the discretionary termination policy of investors (the principal) when the agent has loss—averse preferences. Our theoretical findings provide several new empirical implications for backloaded compensation and forced managerial turnover. Our model also shows that mandatory deferral regulation governing incentive pay induces investors to terminate the contract relation earlier and results in the more frequent replacement of managers.

Keywords: continuous-time agency, executive compensation, reference-dependent utility, managerial turnover, mandatory deferral of incentive pay

JEL Classification: D82, D86, D92, G02, G34, M12