Contract Horizon, Severance Pay, and Turnover

Renewable fixed-term contracts are widespread in executive compensation. This paper shows why these contracts are optimal and how they affect managers' and boards' behavior. When managers' match-quality changes over time, offering severance pay for premature dismissal can discourage window dressing by managers trying to avoid dismissal. However, to be effective, severance pay must increase with the contract's length. Fixed-term contracts that offer little severance pay if not extended provide a balance between reducing the likelihood of window dressing and lowering dismissal costs. The predicted determinants of contract length are supported by empirical evidence and have implications for managers' turnover-performance sensitivity