Managerial replacement strategies and severance pay

This paper demonstrates the benefits to shareholders of offering severance packages to managers. We show that severance pay is not merely a way to coax underperforming managers to step aside. Rather, a manager's efforts can pave the way for the manager's successor, and thereby attract more talented potential replacements. We consider two settings that differ on whether or not the shareholder can fully commit to a replacement strategy. In both settings the shareholder makes replacement decisions based on output and the availability of a suitable replacement candidate at the end of the first period. When the shareholder can fully commit to the circumstances of replacement, severance pay serves solely to improve contract efficiency, because the probability of the replacement candidate emerging is influenced by the incumbent manager's effort. In the setting without full commitment, severance pay not only improves contract efficiency but also allows the shareholder to expand the set of credible output-contingent replacement strategies. Generally, severance pay motivates managers to build value in the firm despite the possibility that in doing so, they make their own services obsolete.