Career Concerns and Contingent Compensation

Abstract

This paper considers a two-period model in which managers have superior information about their ability to forecast the realization of given investment projects. Firms compete for managers by offering short-run contracts. As future salaries depend on current play through its impact on managerial reputation, managers' investment decisions are affected by their concern for their future careers. We analyze the interaction between these implicit incentives, created by managers' career concerns, and the explicit incentives made possible by contingent compensation. We show that managers' career concerns create perverse incentives that are robust to the introduction of contingent contracting. We also find that while managerial compensation is monotonically increasing in profit at date 2, it is not at date 1. Two numerical exercises relate the implications of our results to the literature on the link between pay and performance. In line with empirical findings, we find that: i) the pay-performance sensitivity is highest in the final period of managers' employment; ii) higher pay-performance sensitivities are associated with a lower variance of profits.