Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse





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    • Ingolf Dittmann is at Erasmus University, Rotterdam. Ernst Maug is at the University of Mannheim. Oliver Spalt is at Tilburg University. The authors are grateful to seminar participants at the University of Cologne, Frankfurt, Georgia State, Humboldt, Mannheim, Maryland, Tilburg, the European Finance Association meeting in Ljubljana, the NBER Behavioral Economics Working Group Meeting at Yale, the European Accounting Association meeting in Rotterdam, the JFI-Conference on “Financial Contracting,” the 6th Oxford Finance Symposium, the DGF-conference in Dresden, and the GEABA-conference in Tübingen, and also to Bo Becker, Axel Börsch-Supan, Alex Edmans, Xavier Gabaix, Campbell Harvey (the Editor), Gerard Hoberg, Andreas Knabe, Matjaz Koman, Roy Kouwenberg, David Larcker, Christian Laux, David De Meza, Werner Neus, and an anonymous referee for valuable feedback. We further thank the collaborative research centers SFB 649 on “Economic Risk” in Berlin and the SFB 504 “Rationality Concepts, Decision Making and Economic Modeling” for financial support. Ingolf Dittmann acknowledges financial support from NWO through a VIDI grant. Ernst Maug thanks the University of New South Wales for the hospitality he received during his sabbatical.


This paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal-agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and that drops discontinuously to the lowest possible payout for low outcomes. Finally, we identify the critical features of the loss-aversion model that render optimal contracts convex.