Relative Performance Evaluation and Target Setting

Abstract

It is well known that compensation contracts can improve risk sharing by incorporating information about peer performance ex post, i.e., once the performance of a unit as well as its peers is observed. In this study, we examine whether peer performance is also used ex ante, i.e., when setting performance targets at the beginning of a period. We analyze data on 2008-2010 performance targets from 354 units of a national agency responsible for reintegration of the long-term unemployed into the labor market. We find evidence that a target for a performance measure is strongly positively associated with past peer performance on the same measure as well as past peer performance on a different measure. Thus, performance targets are lower whenever past peer performance is weak on at least one of its dimensions. We also find that the relative weights on different measures of peer performance are proportional to their capacity to filter out common risks. We conclude that using information about past peer performance improves risk sharing and alleviates adverse incentive effects associated with setting targets based on a unit’s own past performance.