Dynamic Compensation Contracts with Private Savings

Abstract

This article studies a dynamic agency problem in which a risk-averse agent can save privately. In the optimal contract, (i) cash compensations exhibit downward rigidity to failures; (ii) permanent pay raises occur when the agent’s historical performance is sufficiently good; (iii) and when the agent is dismissed due to poor performance, he walks away with severance pay to support his post-firing consumption at the current compensation level. Thus, the theory can simultaneously explain the popularity of optionslike compensation contracts and the increasing incidence of forced turnovers with sizeable severance pay. (JEL D86, J31, J33)