Optimal Compensation Contracts with Pay-for-Performance and Termination Incentives

Abstract

This paper studies optimal compensation contracts in the presence of both pay-for-performance and termination incentives. While these incentives have been studied independently, this paper s model is the first to incorporate both. The primary result is that pay-for-performance and the threat of termination are substitute incentive devices; holding effort constant, optimal pay-for-performance incentives are increasing in the cost of termination. Our test of this result compares compensation contracts of managers of real estate investment trusts and general partners of real estate limited partnerships. REIT managers wealth changes by $25.30 per $1,000 change in REIT value. Compensation for general partners, who are more costly to fire than REIT managers, changes by $253.57 per $1,000 change in partnership value.