Only Time Will Tell: A Theory of Deferred Compensation
45 Pages Posted: 9 Apr 2019
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Only Time Will Tell: A Theory of Deferred Compensation
Date Written: April 2019
Abstract
This paper provides a complete characterization of optimal contracts in principal-agent settings where the agent's action has persistent effects. We model general information environments via the stochastic process of the likelihood-ratio. The martingale property of this performance metric captures the information benefit of deferral. Costs of deferral may result from both the agent's relative impatience aswell as her consumption smoothing needs. If the relatively impatient agent is risk neutral, optimal contracts take a simple form in that they only reward maximal performance for at most two payout dates. If the agent is additionally risk-averse,optimal contracts stipulate rewards for a larger selection of dates and performance states: The performance hurdle to obtain the same level of compensation is in-creasing over time whereas the pay-performance sensitivity is declining. We derive testable implications for the optimal duration of (executive) compensation and the maturity structure of claims in financial contracting settings.
Keywords: Compensation design, duration of pay, Informativeness principle, moral hazard, Persistence, Principal-Agent Models
JEL Classification: D86
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