Contract Horizon, Severance Pay, and Turnover
AFA 2018 Philadelphia Meetings Paper
61 Pages Posted: 1 Nov 2016 Last revised: 24 Apr 2019
Date Written: April 22, 2019
Renewable fixed-term contracts are wide-spread in executive compensation. This paper analyzes why these contracts are optimal and what determines their length. When managers' match-quality changes over time, offering severance pay for premature dismissal can discourage managers with deteriorating match-quality from window dressing to avoid dismissal. However, to be effective, severance pay must increase with the contract's length. Thus, the trade-off is that shorter contracts help economize on severance pay during a contract's term, but can lead to more window dressing close to its end/renewal when dismissal is cheap. Evidence from CEO contracts supports the predicted determinants of contract length.
Keywords: contract length, contract horizon, severance pay, voluntary and forced turnover, renewable fixed-term contracts, asymmetric information
JEL Classification: G30, G34, D82
Suggested Citation: Suggested Citation