DP16288 Contract Length and Severance Pay

Author(s): Vladimir Vladimirov
Publication Date: June 2021
Keyword(s): Asymmetric information, contract horizon, contract length, renewable fixed-term contracts, Severance pay, turnover-performance sensitivity, voluntary and forced turnover
JEL(s): D82, G30, G34
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16288

Renewable fixed-term contracts are widespread in executive compensation. This paper studies why these contracts are optimal, what determines their length, and how that length affects managerial behavior. The model relates a contract's length to the period during which dismissing a manager triggers severance pay. Though longer contracts are more costly to terminate, their severance protection can discourage managers from trying to avoid replacement through window dressing or concealing soft information. Thus, the board's choice of contract length balances higher replacement costs with a higher likelihood of window dressing. The predicted determinants of contract length and severance pay are supported empirically.