DP9182 | The structure of CEO pay: pay-for-luck and stock-options

Publication Date

21/10/2012

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Abstract

We develop a stylized model of efficient contracting in which firms compete for CEOs. The optimal contracts are designed to retain and insure CEOs. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. We show that the optimal contract can be implemented with stock-options based on a single performance measure which does not filter out luck. When the capacity to dismiss underperforming CEOs differs across firms, and the ability of different CEOs is more or less precisely estimated ex-ante, endogenous matching between CEOs and firms can explain the observed association between pay-for-luck and bad corporate governance. The model also predicts that an improvement in the governance of badly governed firms has spillover effects that increase CEO pay in all firms.