Pay-for-Luck in CEO Compensation: Matching and Efficient Contracting

Abstract

We develop a stylized model of efficient contracting with matching between firms and managers with state-contingent reservation utility. We show that the optimal contract is designed to retain and insure the manager. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. This contract can be implemented with call options based on a single performance measure which generally does not filter out luck. When costs of involuntary managerial turnover differ across firms, and the abilities of different managers are more or less precisely estimated ex-ante, the model can also explain the observed association between pay-for-luck and bad corporate governance.