Sticks or Carrots? Optimal CEO Compensation when Managers are Loss-Averse

Dittmann, Ingolf; Maug, Ernst G.; Spalt, Oliver G.

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Sticks or Carrots? Optimal CEO Compensation when Managers are Loss-Averse

Journal of Finance, Vol. 65, No. 6, pp. 2015-2050, 2010

46 Pages Posted: 14 Jul 2006 Last revised: 19 Dec 2010

See all articles by Ingolf Dittmann

Ingolf Dittmann

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; Erasmus Research Institute of Management (ERIM); European Corporate Governance Institute (ECGI)

Ernst G. Maug

University of Mannheim Business School; European Corporate Governance Institute (ECGI)

Oliver G. Spalt

University of Mannheim - Business School; European Corporate Governance Institute (ECGI)

Date Written: March 24, 2008

Abstract

This paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal-agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parametrizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and drops discontinuously to the lowest possible payout for low outcomes. We identify the critical features of the loss-aversion model that render optimal contracts convex.

Keywords: Stock Options, Executive Compensation, Loss Aversion

JEL Classification: G30, M52

Suggested Citation: Suggested Citation

Dittmann, Ingolf and Maug, Ernst G. and Spalt, Oliver G., Sticks or Carrots? Optimal CEO Compensation when Managers are Loss-Averse (March 24, 2008). Journal of Finance, Vol. 65, No. 6, pp. 2015-2050, 2010 , Available at SSRN: https://ssrn.com/abstract=914502