Incentive Pay Prior to CEO Turnover When Effort Choices Have Lasting Effects

We present a modified principal-agent model to identify a link between the anticipated likelihood of future CEO turnover and the optimal sensitivity of incentive pay to firm performance. The analysis focuses on the optimal sequence of standard one-period incentive contracts when CEO effort choices have lasting effects on firm performance. In such a model, an increase in the anticipated likelihood of turnover reduces the impact of future incentive contracts on current CEO effort, and induces a compensatory increase in the optimal sensitivity of current CEO compensation to current firm performance. We find empirical evidence in support of this prediction for a sample of over 3,000 US firms. Using an executive-specific fixed effects model, we find that among CEOs who depart within two years, the sensitivity of current incentive pay to changes in current firm performance is greater when there is a higher anticipated likelihood of CEO turnover as proxied by departures that reflect a planned succession and departures by CEOs who have reached retirement age. As expected, this increase in the sensitivity of current incentive pay to changes in firm performance is not found if the subsequent turnover is classified as unplanned, and thus not anticipated by the firm