Have we made ourselves (too) clear?—Performance effects of the incentive explicitness in CEO compensation

Abstract

The design of chief executive officer (CEO) compensation arrangements represents an important mechanism for aligning the goals of firms' shareholders with those of their managers. The explicitness of such goals (incentive explicitness) plays a vital role in this regard. We define incentive explicitness as the degree of CEOs' ex-ante knowledge of the exact performance conditions set out in their compensation arrangements. We argue that incentive explicitness has an inverted U-shaped effect on firm performance. Extending agency theory arguments concerning goal incongruence, we claim that this effect stems from two latent mechanisms. On the one hand, incentive explicitness offers benefits derived from the clear performance-reward links that direct CEOs' actions in such a way as desired by shareholders. On the other hand, in the case of over-explicit incentives, benefits intertwine with the costs that materialize in the form of reduced motivation on the part of CEOs. When incentives are over-explicit, successful strategies are attributed to shareholders' foresight rather than to CEOs’ managerial capabilities.