CEO Horizon, Optimal Pay Duration, and the Escalation of Short-Termism

Abstract

This paper studies optimal CEO contracts when managers manipulate their performance measure, sometimes at the expense of firm value. Optimal contracts defer compensation. The manager’s incentives vest over time at an increasing rate, and compensation becomes increasingly sensitive to short-term performance. This process generates an endogenous CEO horizon problem whereby managers intensify performance manipulation in their final years in office. Contracts are designed to foster effort while minimizing the adverse effects of manipulation. We characterize the optimal mix of short- and long-term compensation along the manager’s tenure, the optimal vesting period of incentive pay, and the resulting dynamics of managerial short-termism over the CEO’s tenure. Our paper provides a rationale for issuing stock awards with performance-based vesting provisions, a practice increasingly adopted by U.S. firms.