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Dynamic Incentive Accounts

Alex Edmans
University of Pennsylvania - The Wharton School

Xavier Gabaix
New York University - Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Tomasz Sadzik
New York University

Yuliy Sannikov
University of California, Berkeley - Department of Economics


August 24, 2009


Abstract:     
Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. We derive the optimal contract in a setting where the CEO can affect firm value through both productive effort and costly manipulation, and may undo the contract by privately saving. The optimal contract takes a surprisingly simple form, and 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. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO's employment and after he quits, to deter short-termist actions before retirement.

Keywords: Contract theory, executive compensation, incentives, principal-agent problem, manipulation, private saving, vesting

JEL Classifications: D2, D3, G34, J3

Working Paper Series

Date posted: March 18, 2009 ; Last revised: August 25, 2009

Suggested Citation

Edmans, Alex, Gabaix, Xavier, Sadzik, Tomasz and Sannikov, Yuliy, Dynamic Incentive Accounts (August 24, 2009). Available at SSRN: http://ssrn.com/abstract=1361797


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Contact Information

Alex Edmans (Contact Author)
University of Pennsylvania - The Wharton School ( email )
3641 Locust Walk
Philadelphia, PA 19104-6365
United States
Xavier Gabaix
New York University - Stern School of Business ( email )
Stern School of Business
44 West 4th Street, Suite 9-190
New York, NY 10012-1126
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Centre for Economic Policy Research (CEPR) ( email )
90-98 Goswell Road
London EC1V 7RR United Kingdom
Tomasz Sadzik
New York University ( email )
New York, NY 10011
United States
Yuliy Sannikov
University of California, Berkeley - Department of Economics ( email )
549 Evans Hall #3880
Berkeley, CA 94720-3880
United States
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