Managerial Expertise, Private Information, and Pay-Performance Sensitivity

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, the 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.