Optimal CEO Compensation when Managers are Loss Averse

by Jim Naughton, for The Harvard Law School Forum at Harvard Law School, December 14, 2009.

In our paper Sticks or Carrots? Optimal CEO Compensation when Managers are Loss Averse, which was recently accepted for publication in the Journal of Finance, we analyze a simple contracting model where the manager is loss averse and explore to what extent its predictions are consistent with salient features of observed compensation contracts. In particular, we suggest a new approach to explaining the almost universal presence of stock options by assuming that manager’s preferences exhibit loss aversion as described by Kahneman and Tversky. More specifically, on the basis of experimental evidence they argue that choices under risk exhibit three features: (i) reference dependence, where agents do not value their final wealth levels, but evaluate outcomes relative to some benchmark or reference level; (ii) loss aversion, which adds the notion that losses (measured relative to the reference level)loom larger than gains; (iii) diminishing sensitivity, so that individuals become progressively less sensitive to incremental gains and incremental losses.

We develop a stylized principal-agent model with a loss-averse agent and show how it can be calibrated to individual CEO data. In the first part of the paper, we consider piecewise linear contracts that consist of fixed salary, stock and one option grant…(continue reading)

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