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Discussion Paper Details

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Title: Only time will tell: A theory of deferred compensation

Author(s): Roman Inderst and Marcus M. Opp

Publication Date: April 2019

Keyword(s): Compensation design, duration of pay, Informativeness principle, moral hazard, Persistence and Principal-Agent Models

Programme Area(s): Industrial Organization

Abstract: This paper provides a complete characterization of optimal contracts in principal-agent settings where the agent's action has persistent effects. We model generalinformation environments via the stochastic process of the likelihood-ratio. Themartingale property of this performance metric captures the information benefit ofdeferral. Costs of deferral may result from both the agent's relative impatience aswell as her consumption smoothing needs. If the relatively impatient agent is riskneutral, optimal contracts take a simple form in that they only reward maximalperformance for at most two payout dates. If the agent is additionally risk-averse,optimal contracts stipulate rewards for a larger selection of dates and performancestates: The performance hurdle to obtain the same level of compensation is in-creasing over time whereas the pay-performance sensitivity is declining. We derivetestable implications for the optimal duration of (executive) compensation and thematurity structure of claims in financial contracting settings.

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Bibliographic Reference

Inderst, R and Opp, M. 2019. 'Only time will tell: A theory of deferred compensation'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13643