The optimal timing of executive compensation

We propose a new continuous-time principal-agent model to study the optimal timing of stock-based incentives, when the effects of managerial actions materialize with a lag and are only progressively understood by shareholders. On the one hand, early contingent compensation hedges the manager against the accumulation of exogenous shocks. On the other hand, the fact that initial information asymmetries between the manager and shareholders are progressively resolved suggests that contingent compensation should be postponed. We introduce two possible types of managerial short-termism, and show that they both result in lower-powered incentives and more deferred compensation

Aversion to the variability of pay and the structure of executive compensation contracts

This paper presents a new implication of an aversion toward the variance of pay (“risk aversion”) for the structure of managerial incentive schemes. In a principal-agent model in which the effort of a manager with mean-variance preferences affects the mean of a performance measure, we find that managerial compensation must be such that the variance of payments is decreasing in effort. From an ex-ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. An important practical implication is that convex incentive contracts do not satisfy this necessary condition for optimality, which calls into question the practice of granting executive stock options. The paper therefore contributes to the debate on the efficiency of executive compensation

Explaining the structure of CEO incentive pay with decreasing relative risk aversion

It is established that the standard principal-agent model cannot explain the structure of commonly used CEO compensation contracts if CRRA preferences are postulated. However, we demonstrate that this model has potentially a high explanatory power with preferences with decreasing relative risk aversion, in the sense that a typical CEO contract is approximately optimal for plausible preference parameters

Aversion to the variability of pay and optimal incentive contracts

In a moral hazard setting with a performance additive in effort and a symmetrically distributed noise term, I show that compensation contracts which are convex in performance are suboptimal when the agent has mean-variance preferences. With step contracts, I show that sticks are more efficient than carrots: an exogenously given lower bound on payments is binding at the optimum. Intuitively, the variance of the agent's pay conditional on a high effort should be as low as possible, while it should be as high as possible conditional on a low effort. From an ex ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. These results call into question the widespread use of stock-options and contracts with rewards-like features to provide incentives to risk averse executives

The effect of risk preferences on the valuation and incentives of compensation contracts

We use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by risk averse managers, in a fairly general setting. We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. Thus, prudence can contribute to explain the prevalence of stock-options in executive compensation. We also present a condition on the utility function which enables to compare the structure of optimal contracts associated with different risk preferences

Downside risk neutral probabilities

Risk neutral probabilities are adjusted to take into account the asset price effect of risk preferences. This paper introduces downside (respectively outer) risk neutral probabilities, which are adjusted to take into account the asset price effect of preferences for downside (resp. outer) risk and higher degree risks. Using risk preference theory, we interpret these three changes in probability measures in terms of risk substitution. With downside risk neutral probabilities, the pricing kernel is linear in wealth. Outer risk neutral probabilities can be viewed as a reasonable approximation of physical probabilities

The structure of CEO pay: pay-for-luck and stock-options

We develop a stylized model of efficient contracting in which firms compete for CEOs. The optimal contracts are designed to retain and insure CEOs. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. We show that the optimal contract can be implemented with stockoptions based on a single performance measure which does not filter out luck. When the capacity to dismiss underperforming CEOs differs across firms, and the ability of different CEOs is more or less precisely estimated ex-ante, endogenous matching between CEOs and firms can explain the observed association between pay-for-luck and bad corporate governance. The model also predicts that an improvement in the governance of badly governed firms has spillover effects that increase CEO pay in all firms

On the Value of Improved Informativeness

One of the main predictions of principal-agent theory, the “informativeness principle”, is often violated in practice. We propose an explanation that emphasizes the role played by the change in the form of the optimal contract that follows an improvement in informativeness. We show that the overall gains from a less noisy performance measure emanate from two sources: the direct effect of a change in the volatility of the performance measure, and the effect of the induced change on the form of the optimal compensation contract. We emphasize that the direct effect can either largely under-estimate or largely overtimate the overall gains from improved informativeness, and we show that these gains can even be nil in some instances

The Optimal Timing of CEO Compensation

This paper extends a standard principal-agent model of CEO compensation by modeling the progressive attenuation of information asymmetries between firm insiders and shareholders in continuous time. In this setting, we show that the optimal timing of compensation results from a tradeoff between the progressive accumulation of noise in the stock price process and the progressive resolution of information asymmetries. Since all points in the stock price process are incrementally informative about the CEO action, we also show that the whole stock price process should a priori be used for compensation purposes. This may however lead CEOs to inefficiently divert resources to repeatedly manipulate the stock price, which is why it might be optimal to use only a few points in the stock price process instead