Firm Performance Pay as Insurance against Promotion Risk

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. 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 its workers' pay structure.

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

JEL Classification: D81, D86, G32