Only Time Will Tell: A Theory of Deferred Compensation

41 Pages Posted: 9 Jan 2017 Last revised: 23 Jun 2020

See all articles by Florian Hoffmann

Florian Hoffmann

Erasmus School of Economics

Roman Inderst

Goethe University Frankfurt

Marcus M. Opp

Stockholm School of Economics - Department of Finance; Swedish House of Finance

Date Written: December 10, 2019

Abstract

This paper characterizes optimal compensation contracts in principal-agent settings where the agent's action has persistent effects. As additional informative signals arrive over time, deferred compensation has the benefit of exploiting better performance measurement which, for any information environment, is captured by the martingale property of the likelihood ratio process. With bilateral risk-neutrality and a relatively impatient agent, optimal contracts are high-powered and feature at most two payout dates regardless of the nature of information arrival. If the agent is additionally risk-averse, rewards are paid out if and only if performance is above a hurdle that is gradually increasing over time. Our precise characterization allows for clear-cut comparative statics predictions on how the timing of pay depends on the nature of information arrival as well as agent characteristics and generates implications for the optimal duration of compensation packages and the maturity structure of claims in financial contracting settings.

Keywords: Compensation design, duration of pay, moral hazard, persistence, principal-agent models, informativeness principle

JEL Classification: D86

Suggested Citation

Hoffmann, Florian and Inderst, Roman and Opp, Marcus M., Only Time Will Tell: A Theory of Deferred Compensation (December 10, 2019). Swedish House of Finance Research Paper No. 19-4, Available at SSRN: https://ssrn.com/abstract=2894496 or http://dx.doi.org/10.2139/ssrn.2894496

Florian Hoffmann (Contact Author)

Erasmus School of Economics ( email )

Burgemeester Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Roman Inderst

Goethe University Frankfurt ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60629
Germany
+49 (69) 798-34601 (Phone)
+49 (69) 798-35000 (Fax)

HOME PAGE: http://www.wiwi.uni-frankfurt.de/en/departments/finance/lehrstuhl/prof-dr-roman-inderst/team

Marcus M. Opp

Stockholm School of Economics - Department of Finance ( email )

SE-113 83 Stockholm
Sweden

Swedish House of Finance

Drottninggatan 98
111 60 Stockholm
Sweden

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