We propose a model of how the retention motive shapes managerial compensation contracts. Once employed, a risk-averse manager acquires imperfectly portable skills whose value is stochastic due to industry-wide demand shocks. The manager’s actions are uncontractible, and the perceived fairness of the compensation contract affects the manager’s motivation. If the volatility of profits is sufficiently large and outside offers are sufficiently likely, the equilibrium contract combines a salary with an own-firm stock option. The model’s predictions are consistent with empirical regularities concerning contractual shape, the magnitude of variable pay, the lack of indexation, and the prevalence of discretionary severance pay.
The paper is forthcoming in Management Science.
Tore Ellingsen is Professor at Stockholm Business School and Professor II at NHH.
Eirik Gaard Kristiansen is Professor at Department of Economics at NHH.
Both are affiliated with the Centre for Business Economics.
The CBE congratulates Ellingsen and Kristiansen.