DP13643 Only time will tell: A theory of deferred compensation

Author(s): Roman Inderst, Marcus M. Opp
Publication Date: April 2019
Keyword(s): Compensation design, duration of pay, Informativeness principle, moral hazard, Persistence, Principal-Agent Models
JEL(s): D86
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13643

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.