Contract Horizon, Severance Pay, and Turnover
AFA 2018 Philadelphia Meetings Paper
49 Pages Posted: 1 Nov 2016 Last revised: 3 Feb 2019
Date Written: February 2, 2019
Managers are often hired with renewable fixed-term contracts. This paper explains why these contracts are suitable and what determines their length by developing a model in which the fit between a firm and its managers changes over time. Offering severance pay for premature termination mitigates managers' incentives to conceal a deteriorating fit. However, paying managers for premature termination tomorrow, increases these incentives today. Renewable fixed-term contracts can balance this trade-off by allowing for dismissal without severance pay on renewal dates. Analyzing the determinants of severance pay and contract length, such as managers' outside options, helps explain several puzzling stylized facts.
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