Firm Performance Pay as Insurance against Promotion Risk

59 Pages Posted: 14 Oct 2020 Last revised: 1 Jun 2022

See all articles by Alvin Chen

Alvin Chen

Stockholm School of Economics | Swedish House of Finance

Date Written: July 30, 2020

Abstract

The prevalence of pay based on risky firm outcomes for non-executive workers presents a puzzling departure from conventional contract theory, which predicts insurance provision by the firm. I revisit this puzzle in a framework with workers who prefer early resolution of uncertainty. When workers at the same firm compete against each other for promotions, the optimal contract features pay based on firm outcomes as insurance against promotion risk. The model’s predictions are consistent with many observed phenomena such as performance-based vesting and overvaluation of equity pay by non-executive workers. It also generates novel predictions linking a firm's hierarchy to the structure of its workers' pay.

Keywords: Insurance, year-end bonus, stock option pay, tournament, optimal contracting, early resolution of uncertainty, Epstein-Zin

JEL Classification: D81, D86, G32

Suggested Citation

Chen, Alvin, Firm Performance Pay as Insurance against Promotion Risk (July 30, 2020). Proceedings of Paris December 2020 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3664250 or http://dx.doi.org/10.2139/ssrn.3664250

Alvin Chen (Contact Author)

Stockholm School of Economics | Swedish House of Finance ( email )

SE-113 83 Stockholm
Sweden

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