Contract Horizon, Severance Pay, and Turnover
AFA 2018 Philadelphia Meetings Paper
61 Pages Posted: 1 Nov 2016 Last revised: 16 May 2019
Date Written: April 22, 2019
Renewable fixed-term contracts are widespread in executive compensation. This paper shows why these contracts are optimal and how they affect managers' and boards' behavior. When managers' match-quality changes over time, offering severance pay for premature dismissal can discourage window dressing by managers trying to avoid dismissal. However, to be effective, severance pay must increase with the contract's length. Fixed-term contracts that offer little severance pay if not extended provide a balance between reducing the likelihood of window dressing and lowering dismissal costs. The predicted determinants of contract length are supported by empirical evidence and have implications for managers' turnover-performance sensitivity.
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