In our paper, Dynamic CEO Compensation, which is forthcoming in the Journal of Finance, we present a fully dynamic model of CEO pay that incorporates many complex features of real-life contracting settings. In particular, it considers multiple periods, risk aversion, private saving, and short-termism. In such settings, the optimal contract is typically very complicated and can only be solved numerically, which makes it difficult to see the intuition and understand which features of the setting are driving which aspects of the contract. Our main methodological contribution is to achieve a surprisingly tractable optimal contract. The model’s closed-form solutions lead to transparency, clarity, and simplicity — they allow the economic forces behind the contract to be transparent, its economic implications to be clear, and in particular practical guidelines on how to reform compensation to address issues that manifested in the recent financial crisis. In particular, we propose a compensation structure based on a system that escrows compensation for a set period of years stretching into the executive’s retirement. The longer time frame is designed to prevent the executive from taking short-term actions that may enrich the manager at the expense of the firm’s future profits. The plan also provides a rebalancing mechanism to maintain a constant percentage of compensation in cash and stock, so that the executive always has sufficient equity in the firm to provide performance incentives — even if the stock price falls.

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