Dynamic Compensation Contracts with Private Savings

Abstract

This paper studies a dynamic agency problem where a risk-averse agent can privately save. In the optimal contract, 1) cash compensations exhibit downward rigidity to failures; 2) permanent pay raises occur when the agent's historical performance is sufficiently good; 3) and when the agent is dismissed due to his poor performance, he walks away with a severance pay to support his post-firing consumption at the current compensation level. Thus, under realistic contracting frictions, seemingly inefficient compensation schemes can indeed be optimal. Several extensions are considered, including the agent's outside option and renegotiation-proof contracts.

Keywords: Continuous-time Contracting, Poisson Process, Wealth Effect, Cost of High-Powered Incentives

JEL Classification: D86, J31, J33