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Pay-for-Luck in CEO Compensation: Matching and Efficient Contracting

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  • Pierre Chaigneau
  • Nicolas Sahuguet

Abstract

We develop a stylized model of efficient contracting with matching between firms and managers with state-contingent reservation utility. We show that the optimal contract is designed to retain and insure the manager. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. This contract can be implemented with call options based on a single performance measure which generally does not filter out luck. When costs of involuntary managerial turnover differ across firms, and the abilities of different managers are more or less precisely estimated ex-ante, the model can also explain the observed association between pay-for-luck and bad corporate governance.

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Bibliographic Info

Paper provided by CIRPEE in its series Cahiers de recherche with number 1224.

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Date of creation: 2012
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Handle: RePEc:lvl:lacicr:1224

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Keywords: CEO pay; corporate governance; pay-for-luck; stock-options;

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  1. Ingolf Dittmann & Ko-Chia Yu, 2009. "How Important Are Risk-Taking Incentives in Executive Compensation?," Tinbergen Institute Discussion Papers 09-076/2, Tinbergen Institute.
  2. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  3. Maug, Ernst & Dittmann, Ingolf, 2007. "Lower Salaries and No Options: The Optimal Structure of Executive Pay," Sonderforschungsbereich 504 Publications 07-41, Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim.
  4. Patrick Legros & Andrew F. Newman, 2003. "Beauty is a Beast, Frog is a Prince: Assortative Matching with Nontransferabilities," Economics Working Papers 0030, Institute for Advanced Study, School of Social Science.
  5. Ingolf Dittmann & Ernst Maug & Oliver Spalt, 2010. "Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse," Journal of Finance, American Finance Association, vol. 65(6), pages 2015-2050, December.
  6. Fabio Feriozzi, 2011. "Paying for observable luck," RAND Journal of Economics, RAND Corporation, vol. 42(2), pages 387-415, 06.
  7. Xavier Gabaix & Augustin Landier, 2008. "Why Has CEO Pay Increased So Much?," The Quarterly Journal of Economics, MIT Press, vol. 123(1), pages 49-100, 02.
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