Only Time Will Tell: A Theory of Deferred Compensation

Abstract

This paper characterizes optimal compensation contracts in principal-agent settings where the agent's action has persistent effects. As additional informative signals arrive over time, deferred compensation has the benefit of exploiting better performance measurement which, for any information environment, is captured by the martingale property of the likelihood ratio process. With bilateral risk-neutrality and a relatively impatient agent, optimal contracts are high-powered and feature at most two payout dates regardless of the nature of information arrival. If the agent is additionally risk-averse, rewards are paid out if and only if performance is above a hurdle that is gradually increasing over time. Our precise characterization allows for clear-cut comparative statics predictions on how the timing of pay depends on the nature of information arrival as well as agent characteristics and generates implications for the optimal duration of compensation packages and the maturity structure of claims in financial contracting settings.