Tunnel-proofing the executive suite: temptation, and the design of executive compensation

This paper considers optimal compensation for a CEO who is entrusted with administering corporate assets honestly.  Optimal compensation designs maximize integrity at minimum cost.  These designs are very 'low powered', i.e., while specifying a lower bound for performance and increasing pay with performance, they increase compensation at a rapidly decreasing rate.  Thus, integrity considerations engender optimal compensation packages that closely resemble the very pervasive 80/120 bonus plans, exactly the sort of compensation which Jensen (2003) argues should compromise integrity.  Under optimal designs, expected compensation increases linearly with firm size, and increases in the market/book ratio.  Moreover, given optimal compensation, CEO asset diversion is limited to high market-to-book firms that have received negative productivity shocks.