Contract Length and Severance Pay
AFA 2018 Philadelphia Meetings Paper
49 Pages Posted: 1 Nov 2016 Last revised: 28 Jun 2021
Date Written: June 26, 2021
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
Suggested Citation: Suggested Citation