Firm Performance Pay as Insurance against Promotion Risk

55 Pages Posted: 14 Oct 2020 Last revised: 9 Nov 2020

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 unfavorable promotion prospects. The model’s predictions are consistent with observed phenomena such as option-like payoffs, performance-based vesting, and over-valuation of equity pay by non-executive workers. It also generates novel predictions linking organizational structure to firm performance 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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