Dynamic Compensation under Uncertainty Shocks and Limited Commitment

This paper studies dynamic compensation and risk management when firms face cash flow volatility shock. Back-loaded compensation with a penalty upon the arrival of the shock is used to incentivize effort and prudence from managers. Thus, implications of the volatility shock depend critically on firms’ ability to commit to future compensa- tion: firms with full commitment power impose high pay-performance sensitivity and large penalties to implement low risk, and defer compensation more when volatility becomes higher. In contrast, firms with limited commitment ability optimally allow excessive risk-taking from managers in exchange for a low pay-performance sensitivity; they expedite compensation when volatility is higher because commitment to future payments becomes less feasible. These predictions shed light on empirical observations particularly the controversial compensation practices during the recent financial crisis.