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Dynamic Incentive Accounts

  • Edmans, Alex

    (University of PA)

  • Gabaix, Xavier

    (NYU)

  • Sadzik, Tomasz

    (NYU)

  • Sannikov, Yuliy

    (Princeton University)

We study optimal executive compensation in a dynamic framework that incorporates many important features of the CEO job absent from a static setting. Shocks to firm value may weaken the incentive effects of securities over time (e.g. drive options out of the money). The CEO can undo the contract by privately saving, and temporarily manipulate the stock price. Despite the complex setup, we obtain a simple closed-form contract. It can be implemented by a "Dynamic Incentive Account": the CEO's expected pay is escrowed into an account, a fraction of which is invested in the firm's stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. If the stock price falls, cash in the account is used to buy additional shares. Unlike the repricing of options, this re-incentivization does not come for free and so the CEO is not rewarded for failure. The account vests gradually both during the CEO's employment and after he quits, to deter short-termist actions before retirement.

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File URL: http://fic.wharton.upenn.edu/fic/papers/10/10-19.pdf
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Paper provided by University of Pennsylvania, Wharton School, Weiss Center in its series Working Papers with number 10-19.

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Date of creation: May 2010
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Handle: RePEc:ecl:upafin:10-19
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