Tunnel-proofing the executive suite: temptation, and the design of executive compensation
This paper considers optimal compensation for a CEO who is entrusted with administering corporate assets honestly. Optimal compensation designs maximize integrity at minimum cost. These designs are very â€˜low powered,â€™ i.e., while specifying a lower bound for performance and increasing pay with performance, they increase compensation at a rapidly decreasing rate. Thus, integrity considerations engender optimal compensation packages that closely resemble the very pervasive 80/120 bonus plans, exactly the sort of compensation which Jensen (2003) argues should compromise integrity. Under optimal designs, expected compensation increases linearly with firm size, and increases in the market/book ratio. Moreover, given optimal compensation, CEO asset diversion is limited to high market-to-book firms that have received negative productivity shocks.
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