Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse

Abstract

This paper analyzes optimal executive compensation contracts when managers are loss averse.We calibrate a stylized principal-agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and drops discontinuously to the lowest possible payout for low outcomes. We identify the critical features of the loss-aversion model that render optimal contracts convex.

Executive Compensation: A Survey of Theory and Evidence

“…The calibration of Dittmann, Maug, and Spalt (2010) demonstrates that the observed use of options can be rationalized by realistic levels of CEO loss aversion, since options provide downside protection. Chaigneau, Sahuguet, and Sinclair-Desgagné (2017) show that options can be optimal if the agent is su¢ ciently prudent (captured by the negative of the ratio of the third and second derivatives of his utility function).…”

“…Baker and Wurgler (2013) divide the behavioral corporate …nance literature into two …elds -managers who are irrational or have non-standard utility functions, and rational managers exploiting ine¢ cient markets. As an example of the former, Dittmann, Maug, and Spalt (2010) argue that incorporating loss aversion can explain the observed mix of stock and options, while standard utility functions cannot. As an example of the latter, Bolton, Scheinkman, and Xiong (2006) show that contracts that emphasize short-term performance may be a rational response to speculative markets.…”

CEO Tournaments: A Cross-Country Analysis of Causes, Cultural Influences, and Consequences

“…11 In a contemporaneous paper, using a sample of firms cross-listed in the United States, Bryan, Nash, and Patel (2012) examine the relation of the elements of compensation to culture and conclude that country cultural characteristics are significant determinants of the relative use of equity-based compensation. 12 Finally, the relation of tournament compensation structure to cultural factors is related to recent literature in finance on behavioral factors, CEO compensation, and actions (e.g., Malmiender and Tate (2005), Dittman, Maug, and Spalt (2010), Cronqvist, Makhija, and Yonker (2011), Gervais, Heaton, and Odean (2011), Graham, Harvey, and Puri (2013). Our research contributes to this literature by providing a direct test of the role culture plays in economic outcomes through CEO tournament structures.…”

Reference Dependence and Labor Market Fluctuations

“…Because workers' preferences in this extended model depend on their expectations (both of the moves of Nature and of the players' strategies), this is not strictly speaking a conventional game, but rather an example of an extensiveform "psychological game" (after Geanakoplos et al (1989)). 14 In general, extending standard game-theoretic solution concepts to this class of games may involve subtleties. However, in the present case, the standard concept of subgame perfect equilibrium (SPE) is defined and analyzed in a completely standard way.…”