Dynamic managerial compensation: On the optimality of seniority-based schemes

We characterize the firm's optimal contract for a manager who faces costly effort decisions and whose ability to generate profits for the firm changes stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent private shocks to the manager's productivity. When the manager is risk-neutral, the optimal contract often entails a simple pay package that is linear in the firm's cash flows. Furthermore, the power of incentives (i.e., the sensitivity of pay to performance) typically increases over time, thus providing a possible justification for the practice of putting more stocks and options in the packages of managers with a longer tenure in the firm. Building on the insights from the risk-neutral case, we then explore the properties of optimal contracts for risk-averse managers. We find that risk-aversion reduces, and in some cases can even revert, the profitability of seniority-based compensation schemes whose power of incentives increases over time.