Private Pre-Decision Information and the Pay–Performance Relation

Abstract

ABSTRACTWe study how the precision of managers’ private post-contract pre-decision information affects the pay–performance relation. Endogenizing the information environment, we find that firms may optimally tie executive pay closer to firm performance as agency problems become more pronounced. Specifically, varying parameters measuring the severity of the agency problem, we identify parameter regions where firms with more pronounced agency problems optimally combine uninformative signals with a higher incentive rate than firms with less pronounced agency problems that optimally choose a perfect signal. We find this relation for various measures of the agency conflict such as the incongruency of the performance measure, its susceptibility to manipulation, or the agent’s degree of risk aversion. Because the pay–performance sensitivity is frequently used for measuring the efficiency of real-world compensation arrangements, our results provide relevant insights for empirical research studying the determinants of the relation between executive pay and firm performance.JEL Classifications: D81; D86; M12; M52.