Aversion to the variability of pay and optimal incentive contracts
In a moral hazard setting with a performance additive in effort and a symmetrically distributed noise term, I show that compensation contracts which are convex in performance are suboptimal when the agent has mean-variance preferences. With step contracts, I show that sticks are more efficient than carrots: an exogenously given lower bound on payments is binding at the optimum. Intuitively, the variance of the agent's pay conditional on a high effort should be as low as possible, while it should be as high as possible conditional on a low effort. From an ex ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. These results call into question the widespread use of stock-options and contracts with rewards-like features to provide incentives to risk averse executives.
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- Carola Frydman & Raven E. Saks, 2010.
"Executive Compensation: A New View from a Long-Term Perspective, 1936--2005,"
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Society for Financial Studies, vol. 23(5), pages 2099-2138.
- Carola Frydman & Raven E. Saks, 2007. "Executive compensation: a new view from a long-term perspective, 1936-2005," Finance and Economics Discussion Series 2007-35, Board of Governors of the Federal Reserve System (U.S.).
- Carola Frydman & Raven E. Saks, 2008. "Executive Compensation: A New View from a Long-Term Perspective, 1936-2005," NBER Working Papers 14145, National Bureau of Economic Research, Inc.
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- Maug, Ernst & Dittmann, Ingolf, 2007. "Lower salaries and no options : the optimal structure of executive pay
[Lower salaries and no options? On the optimal structure of executive pay]," Papers 07-41, Sonderforschungsbreich 504.
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- Ingolf Dittmann & Ernst Maug, 2007. "Lower Salaries and No Options? On the Optimal Structure of Executive Pay," Journal of Finance, American Finance Association, vol. 62(1), pages 303-343, 02. Full references (including those not matched with items on IDEAS)
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