Working Papers

We study the incentive role of severance compensation. In the canonical principal-agent model of Sannikov (2008), we introduce exogenous job destruction risk and show that compensation following job destruction can reduce the costs of incentives prior to job destruction. In an optimal contract, the award of severance suppresses the growth of the agent's value when this value is high, which eliminates the risk of inefficient retirement of the agent. To achieve this, however, severance compensation must exceed the agent's value conditional on job survival, effectively rewarding the agent for "bad luck" in the event of job destruction. High severance awards, thus, are a part of an optimal compensation package. Comparative statics with respect to job destruction risk offer a novel explanation for the positive wage-tenure profile observed in the data: average tenure and compensation should both be higher in jobs less exposed to job destruction risk.