Dynamic CEO Compensation

Dynamic CEO Compensation

By
Alex Edmans, Xavier Gabaix, Tomas Sadzik, Yuliy Sannikov
The Journal of Finance. October
2012, Vol. 67, Issue 5, Pages 1603-1647

We study optimal compensation in a dynamic framework where the CEO consumes in multiple periods, can undo the contract by privately saving, and can temporarily inflate earnings. We obtain a simple closed-form contract that yields clear predictions for how the level and performance sensitivity of pay vary over time and across firms. The contract can be implemented by escrowing the CEO’s pay into a “Dynamic Incentive Account” that comprises cash and the firm’s equity. The account features state-dependent rebalancing to ensure its equity proportion is always sufficient to induce effort, and time-dependent vesting to deter short-termism.