Only Time Will Tell: A Theory of Deferred Compensation

45 Pages Posted: 9 Apr 2019

See all articles by Roman Inderst

Roman Inderst

Goethe University Frankfurt

Marcus M. Opp

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

Date Written: April 2019

Abstract

This paper provides a complete characterization of optimal contracts in principal-agent settings where the agent's action has persistent effects. We model general information environments via the stochastic process of the likelihood-ratio. The martingale property of this performance metric captures the information benefit of deferral. Costs of deferral may result from both the agent's relative impatience aswell as her consumption smoothing needs. If the relatively impatient agent is risk neutral, optimal contracts take a simple form in that they only reward maximal performance for at most two payout dates. If the agent is additionally risk-averse,optimal contracts stipulate rewards for a larger selection of dates and performance states: The performance hurdle to obtain the same level of compensation is in-creasing over time whereas the pay-performance sensitivity is declining. We derive testable implications for the optimal duration of (executive) compensation and the maturity structure of claims in financial contracting settings.

Keywords: Compensation design, duration of pay, Informativeness principle, moral hazard, Persistence, Principal-Agent Models

JEL Classification: D86

Suggested Citation

Inderst, Roman and Opp, Marcus M., Only Time Will Tell: A Theory of Deferred Compensation (April 2019). CEPR Discussion Paper No. DP13643, Available at SSRN: https://ssrn.com/abstract=3368140

Roman Inderst (Contact Author)

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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