How to Optimize Executive Incentives

When You Have the Right Leader at the Wrong Time

Leaders might deserve dismissal when they behave badly or underperform, but some can lose their jobs for simply having the right skills at the wrong time when market conditions shift. “Over time, changes in business conditions may call for a change of top management to seize new opportunities,” professor M. Cecilia Bustamante and her co-authors write in a forthcoming Journal of Finance paper.

Adopting new production techniques, for example, might require someone with technical or manufacturing skills. Expanding overseas might require someone with global experience. Bringing diverse teams together during a merger or acquisition might require a master communicator.

“If the incumbent lacks the vision or skills necessary to implement such transformations, the appointment of new management is the only way for the firm to successfully pursue its course,” the authors write.

Bustamante, a finance professor at the University of Maryland’s Robert H. Smith School of Business, says growth-induced turnover complicates the process of creating optimal incentive packages for executives.

If leaders anticipate that their tenure will be short — especially in high-growth industries — they will resist deferred compensation, a standard feature of incentive contracts designed to reduce firm costs.

Instead, managers will demand generous signing bonuses and other features to front-load their contracts. “Thus the firm may face a dilemma,” the authors write. “By changing management to adapt to evolving business conditions, it may increase the costs of incentive provision.”

In some cases a firm might actually be better off skipping growth opportunities and saving the costs of inefficient terminations. Bustamante and her co-authors present a model that predicts these dynamics and offers guidance to firms facing the dilemma.

“The optimal dynamic contract may grant partial job protection whereby the firm insulates its managers from the risk of growth-induced dismissal and foregoes attractive opportunities when they come after periods of good performance,” they authors conclude.

Read more: Agency, Firm Growth and Managerial Turnover is featured in the Journal of Finance.