Behavioral Agency Model: A Target-Oriented Approach for Executive Incentives

Abstract

Recent empirical studies in Behavioral Agency Model (see Pepper and Gore, 2012) on executive compensations make evidence how the agent attitude to risk influences the subjectively perceived incentive value. The paper sets out a compensation schedule matching multiple goals: (1) aligning the incentives with the executive subjectively perceived fair and equitable compensation; (2) discouraging the executive excessive risk-taking; (3) providing an approach to calculate the certainty equivalent of the uncertain compensation. To hit the first goal we suggest to use the target-oriented decision approach (see Bordley and LiCalzi, 2000) able to guide the agent in eliciting her subjective value function through the assessment of the (uncertain) target to hit. The proposed approach is compatible with prospect theory (see Kahneman and Tversky, 1979). With reference to the second goal involving the problem on how prevent moral hazard phenomena, we suggest to insert an event-linked option. That warranty ties the compensation payment to the outgoing a set of given performance indicators taken as benchmarks. The third goal is achieved using the notion of actuarial zero-utility premium principle extended to prospect theory (see Kaluszka and Krzeszowiec, 2012, 2013). To explicit the agent subjective value function we suggest an interactive graphical method proposed by Goldstein and Rothschild (2014) based on the Distribution Builder (see Sharpe et al., 2000). Our approach generalizes the Pepper and Gore (2012, 2013) compensation formula and provides a normative foundation for constructing compensation schemes, which are coherent with Savage’s (1954) rationality axioms and prospect theory as well.