Contract Length and Severance Pay

Abstract

Renewable fixed-term contracts are widespread in executive compensation. This paper studies why these contracts are optimal, what determines their length, and how that length affects managerial behavior. The model relates a contract's length to the period during which dismissing a manager triggers severance pay. Though longer contracts are more costly to terminate, their severance protection can discourage managers from trying to avoid replacement through window dressing or concealing soft information. Thus, the board's choice of contract length balances higher replacement costs with a higher likelihood of window dressing. The predicted determinants of contract length and severance pay are supported empirically.

Keywords: contract length, contract horizon, severance pay, renewable fixed-term contracts, voluntary and forced turnover, turnover-performance sensitivity, asymmetric information

JEL Classification: G30, G34, D82