Dynamic Compensation Under Uncertainty Shocks and Limited Commitment

Abstract

This article studies dynamic compensation and risk management under cash-flow volatility shocks. The optimal contract depends critically on firms’ ability to make good on promised future payments to managers. When volatility is low, firms with full commitment ability implement high pay–performance sensitivity to motivate effort from managers, and they impose large penalties on the arrival of volatility shocks to incentivize prudent risk management. In contrast, firms with limited commitment may allow excessive risk taking in exchange for low pay–performance sensitivity. When volatility becomes high, firms with full commitment defer compensation more, whereas firms with limited commitment must expedite payments.

CEO Compensation Incentives and Playing It Safe: Evidence from FAS 123R

“…We report these results in Appendix IB.7 of the Supplementary Material and find that a negative impact of FAS 123R on risk-taking and firm value of treated firms becomes even stronger as the identification threshold increases. Second, we exclude firms that started voluntarily recognizing option expense at fair value prior 11 Unexplained variation in ALL_OTHER_COMPENSATION could stem from nuances associated with contracted severance pay (see Cadman, Campbell, and Klasa (2016)), deferred versus expedited pay (see Feng (2021)), and internal tournament-based incentives (see Kini and Williams (2012)). It only became mandatory for firms to disclose contracted severance pay, as distinct from vested severance pay, after the FAS 123R reform.…”

“…Unexplained variation in All Other Compensation could stem from nuances associated with contracted severance pay (seeCadman, Campbell and Klasa (2016)), deferred versus expedited pay (seeFeng (2021)), and internal tournament-based incentives (seeKini and Williams (2012)). It only became mandatory for firms to disclose contracted severance pay, as distinct from vested severance pay, after the FAS 123R reform.…”