Abstract
This paper presents a new implication of an aversion toward the variance of pay (“risk aversion”) for the structure of managerial incentive schemes. In a principal-agent model in which the effort of a manager with mean-variance preferences affects the mean of a performance measure, we find that managerial compensation must be such that the variance of payments is decreasing in effort. From an ex-ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. An important practical implication is that convex incentive contracts do not satisfy this necessary condition for optimality, which calls into question the practice of granting executive stock options. The paper therefore contributes to the debate on the efficiency of executive compensation.
Highlights
The alignment of interests between the manager and the shareholders of a firm is a corporate governance problem of the first order
We argue that the average pay-performance sensitivity, which does not account for the incentive effect of the structure of executive compensation, does not accurately measure the incentives of risk averse managers
This paper studied the implications of an aversion towards the variance of payments for the design of managerial incentive contracts
Summary
The alignment of interests between the manager and the shareholders of a firm is a corporate governance problem of the first order. There are three types of papers that analyze the structure of executive compensation with risk averse CEOs. First, some papers use the expected utility approach but assume a given contract which is linear in the performance measure(s) (e.g., Gibbons, Murphy 1992; Holmstrom, Tirole 1993; Garen 1994), so that they do not study the effect of risk aversion on the structure of the optimal contract. A number of papers postulate mean-variance preferences, but they assume that compensation is linear in the performance measure(s), so that they do not derive implications for the effect of risk aversion on the form of the optimal contract (e.g., Zabojnik 1996; Jin 2002; Bolton et al 2006).
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