Managerial Expertise, Private Information, and Pay-Performance Sensitivity
TL;DR: This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities, and identifies plausible circumstances under which risk and incentives are positively associated.
Abstract: This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities. The model presumes that the rate at which a manager's opportunity wage increases in his expertise depends on the nature of that expertise, i.e., whether it is general or firm specific. The analysis demonstrates that when managerial expertise is largely firm specific (general), the optimal pay-performance sensitivity is lower (higher) than its optimal value in a benchmark setting of symmetric information. Furthermore, when managerial skills are largely firm specific (general), the optimal pay-performance sensitivity decreases (increases) as managerial skills become a more important determinant of firm performance. Unlike the standard agency-theoretic prediction of a negative trade-off between risk and pay-performance sensitivity, this paper identifies plausible circumstances under which risk and incentives are positively associated. In addition to providing an explanation for why empirical tests of risk-incentive relationships have produced mixed results, the analysis generates insights that can be useful in guiding future empirical research.
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TL;DR: This article developed a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006, finding that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly-hired CEOs.
Abstract: This study focuses on the relation between current compensation and past performance measures as signals of a CEO’s ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly-hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic interaction between incentives and performance.
105 citations
Cites background from "Managerial Expertise, Private Infor..."
...(A.9) We infer that the coefficient )( 00 aβ belongs to a direct revelation mechanism if it is increasing in Period 0 ability (i.e., 0) ≥( 00′ aβ ), in agreement with Salanie (2005, p. 31) and Dutta (2008)....
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...21 2 1001 2 1100111001110011 2 ccRayaaayadzayzraya a a σδββλβλα −−−+= ∫ 9 This is a common assumption in mechanism design (Bolton and Dewatripont 2005; Salanie 2005; Dutta 2008)....
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...Second, the agent’s ability could be multidimensional (McAfee et al. 1989; Dutta 2008)....
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...As in Dutta (2008), Datar et al. (2001), Holmstrom and Milgrom (1987), and Feltham and Xie (1994), we also assume the agent has constant absolute risk aversion (utility) with a coefficient of absolute risk aversion (CARA) of R such that his Period 0 utility is: ]}2/)())),((,([exp{))()),),((,(( 0 2…...
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TL;DR: This paper developed a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006, finding that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs.
Abstract: This study focuses on the relation between current compensation and past performance measures as signals of a chief executive officer's (CEO's) ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993–2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic intera...
87 citations
Posted Content•
TL;DR: This paper developed an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings, which has implications for incentive compensation, reporting quality, firm value, and information rents.
Abstract: Building on archival, anecdotal, and survey evidence on managers' roles in accounting manipulations, I develop an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings. This power has implications for incentive compensation, reporting quality, firm value, and information rents. Predictions from the model provide potential explanations for the differing results from recent empirical studies on the impact of regulatory interventions like SOX and the extent to which the CEO's or CFO's incentives significantly impact on earnings management. The model also identifies conditions under which either a powerful or a non-powerful CEO can extract rents, which can help explain mixed empirical results on the association between CEO power and "excessive" compensation.
77 citations
Additional excerpts
...Similar to this paper, Dutta (2008) features countervailing incentives in a LEN model with adverse selection, but in Dutta (2008), countervailing incentives are driven by the correlation between a productive agent s productivity and her outside option or reservation wage....
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TL;DR: This paper investigated managerial skills that are essential for managers' job promotion and found that a manager's own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds.
Abstract: Based on the talent management literature, this paper investigates managerial skills that are essential for managers’ job promotion. Using arguments from the human and social capital literature and following tournament logic, we claim that a manager’s own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds. Studying 7,003 promotions to middle management and 3,147 promotions to senior management, we find broad support for our hypotheses, but find also that network size no longer predicts promotion to senior management. Our findings have implications for individual career development and talent management programs.
67 citations
Cites background from "Managerial Expertise, Private Infor..."
...We distinguish between managers’ experience (e.g., Schmidt, Hunter, & Outerbridge, 1986) – defined as their work tenure (Fisher & Govindarajan, 1992) – and managers’ expertise (e.g., Dutta, 2008) – defined as their focus in a specific work domain....
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TL;DR: This paper developed an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings, which has implications for incentive compensation, reporting quality, firm value, and information rents.
67 citations
References
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TL;DR: In this paper, the authors review the role of performance measures in compensation contracts, and compare how information is aggregated for compensation purposes versus valuation purposes, and discuss the formulation of models of incentive problems caused by moral hazard and adverse selection problems.
755 citations
TL;DR: This article developed a theory of stock-based compensation contracts for the chief executive officers (CEOs) of firms and confronted the theoretical predictions with recent CEO compensation data, and showed a positive and economically meaningful relationship between stockbased pay-sensitivities and CEO reputation.
559 citations
"Managerial Expertise, Private Infor..." refers background in this paper
...Empirical evidence in Anderson et al. (2000), Core and Guay (2001), Ittner et al. (2003), and Murphy(2003) suggest that performance-based pays (through stock options and other performance measures) play a more prominent role in knowledge-intensive new-economy firms than in traditional firms....
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...…managers in new economy knowledge-based firms.20 Consistent with this prediction, Anderson et al. (2000), Core and Guay (2001), Ittner et al. (2003), and Murphy (2003) find that performance-based compensation is more prominent in knowledge-intensive new economy firms than in traditional firms....
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TL;DR: This paper examined determinants of non-executive employee stock option holdings, grants, and exercises for 756 firms during 1994-1997 and found that firms use greater stock option compensation when facing capital requirements and financing constraints.
527 citations
TL;DR: In this article, the determinants and performance consequences of equity grants to senior-level executives, lower-level managers, and non-exempt employees of "new economy" firms were examined.
Abstract: The paper examines the determinants and performance consequences of equity grants to senior-level executives, lower-level managers, and non-exempt employees of "new economy" firms. We find that many of the equity grant determinants and their relative importance vary significantly between new and old economy firms. In addition, we find that employee retention objectives, which new economy firms rank as the most important goal of their equity grant programs, have a significant impact on new hire grants, but not on annual, ongoing grants. Our exploratory performance tests indicate that lower than expected option grants and/or existing option holdings are associated with lower accounting and stock price performance in subsequent years. However, we find that greater than expected option and equity grants and holdings have little consistent association with future performance.
521 citations
TL;DR: In this article, the authors consider the problem of how to allocate a resource among divisions when the productivity of the resource in each division is known only to the division manager, and they show that certain types of transfer pricing schemes are optimal.
Abstract: This paper considers the question: How should a firm allocate a resource among divisions when the productivity of the resource in each division is known only to the division manager? Obviously if the divisions as represented by their managers are indifferent among various allocations of the resource, the headquarters can simply request the division managers to reveal their private information on productivity knowing that the managers have no incentive to lie. The resource allocation problem can then be solved under complete or at least symmetric information. This aspect is a flaw in much of the recent literature on this topic, i.e., there is nothing in the models considered which makes divisions prefer one allocation over another. Thus, although in some cases elaborate allocation schemes are proposed and analyzed, they are really unnecessary. In the model we develop, a division can produce the same output with less managerial effort if it is allocated more resources, and effort is costly to the manager. We further assume that this effort is unobservable by the headquarters, so that it cannot infer divisional productivity from data on divisional output and managerial effort. Given these assumptions, we seek an optimal resource allocation process. Our results show that certain types of transfer pricing schemes are optimal. In particular, if there are no potentially binding capacity constraints on production of the resource, then an optimal process is for each division to choose a transfer price from a schedule announced by the headquarters. Division managers receive a fixed compensation minus the cost of the resource allocated to them at the chosen transfer price. Resources are allocated on the basis of the chosen transfer prices. If there is a potentially binding constraint on resource production, a somewhat more complicated, but similar, scheme is required.
488 citations