Paying for observable luck

Abstract

This article examines why CEOs are rewarded for luck, namely for observable shocks beyond their control. I propose a simple hidden action model where the agent has implicit incentives to avoid bankruptcy. After signing the contract, but before acting, the agent observes a signal on future luck. Implicit incentives are weaker after good news, and call for higher pay‐for‐performance sensitivity in good times. As a result, managerial pay is tied to luck. The model is also consistent with recent evidence of asymmetric pay for luck, that is, a larger exposure of managerial pay to good luck than to bad.