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Tunnel-proofing the executive suite: temptation, and the design of executive compensation

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  • Thomas H. Noe

Abstract

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 ‘low powered,’ 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.

Suggested Citation

  • Thomas H. Noe, 2008. "Tunnel-proofing the executive suite: temptation, and the design of executive compensation," OFRC Working Papers Series 2008fe13, Oxford Financial Research Centre.
  • Handle: RePEc:sbs:wpsefe:2008fe13
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    File URL: http://www.finance.ox.ac.uk/file_links/finecon_papers/2008fe13.pdf
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    Keywords

    incentives; managerial compensation; agency;

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