DP5713 CEO Compensation and Strategy Inertia

Author(s): Roman Inderst, Holger M Mueller
Publication Date: June 2006
Keyword(s): CEO compensation, entrenchment, stock options
JEL(s): D82, D86, G34
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5713

This paper considers the joint optimal design of CEOs' on-the-job compensation and severance pay in a general optimal contracting framework. We obtain a novel argument for high-powered, non-linear CEO compensation such as bonus schemes and option grants that is different from existing arguments based on moral hazard and risk taking. Based on this argument, the CEO's optimal on-the-job compensation scheme is designed to minimize the use of costly severance pay to reduce CEO entrenchment, thus minimizing the CEO's informational rents. Our model generates novel empirical predictions concerning the interrelation of CEOs' on-the-job compensation and severance pay as well as CEO turnover which, to the extent that they have been tested, are consistent with the empirical evidence.