Bonus Contracts Research Articles

On the Valuation and Incentive Effects of Executive Cash Bonus Contracts

Executive compensation packages are often valued in an inconsistent manner: while employee stock options (ESOs) are typically valued ex-ante, i.e., before uncertainties are resolved, cash bonuses are valued ex-post, i.e., by discounting the realized cash grants. Such a lack of consistency can, potentially, distort empirical results. A related, yet mostly overlooked, problem is that when ex-post valuation is used pay-performance measures cannot be well defined. Consistent use of ex-ante valuation for all components of a compensation package would simultaneously resolve both of these problems and provide a natural framework for the analysis of agency problems. In this paper, we perform ex-ante valuation of cash bonus contracts as if the executive's performance were measured by the company stock price, demonstrate how the shape of the bonus contract influences the executive's attitude toward risk, and study the pay-performance sensitivity of such contracts. We commence by demonstrating that a typical executive bonus contract with a linear incentive zone has a payoff structure equivalent to a portfolio of standard and binary European call options so that the ex-ante contract value is given by the linear combination of Black and Scholes call and binary call prices, with the strike prices at the boundary points of the incentive zone. Assuming that a risk neutral executive can choose the level of stock price volatility by selecting a set of projects at origination, we show that bonus contract terms can dramatically affect the executive's risk taking behavior and pay-performance incentives. Our results are extended to bonus contracts with non-linear incentive zones, and performance share contracts with vesting risk. Several testable predictions are made, and venues of future research outlined.

Risk Taking and Optimal Contracts for Money Managers

We develop a general model of delegated portfolio management, with the feature that the agent can control the riskiness of the portfolio. This represents a departure from the existing literature on agency theory in that moral hazard is not only effort exertion but also risk taking behavior. The principal’s problem now involves an incentive-compatibility constraint on risk, which we characterize. Under general conditions, we show that the optimal contract is simply a bonus contract: the agent is paid a fixed sum if the portfolio return is above a threshold. We derive a criterion to decide whether the optimal contract induces excessive or insufficient risk. If a deviation from efficient risk taking causes a large (small) reduction in the expected return of the portfolio, the optimal contract induces excessive (insufficient) risk. In other words, the cheaper it is to play with risk, the less risk the agent takes.

Performance Standards in Incentive Contracts

Research in incentives has focused on performance measures and pay-performance sensitivities but has largely ignored a third significant dimension: the performance standard. Performance standards generate important incentives whenever plan participants can influence the standard-setting process. I describe management bonus contracts and the role of performance standards, distinguishing between standards that are directly affected by management actions in the current or prior year, and standards that are less easily affected. I show that companies choose external standards when prior-year performance is a noisy estimate of contemporaneous performance. In addition, companies using budget-based and other internally determined performance standards have less-variable bonus payouts, and are more likely to smooth earnings from year to year, than companies using externally determined standards.

Government Deposit Insurance and the Diamond-Dybvig Model

The apparent banking market failure modeled by Diamond and Dybvig [1983] rests on their inconsistently applying their “sequential servicing constraint” to private banks but not to their government deposit insurance agency. Without this inconsistency, banks can provide optimal risk-sharing without tax-based deposit insurance, even when the number of “type 1” agents is stochastic, by employing a “contingent bonus contract.” The threat of disintermediation noted by Jacklin [1987] in the nonstochastic case is still present but can be blocked by contractual trading restrictions. This article complements Wallace [1988], who considers an alternative resolution of this inconsistency.

Limited Liability and Bonus Contracts

This paper studies the nature of incentive contracts between a risk‐neutral principal and a risk‐neutral agent under the constraint that the agent's liability is limited. A necessary and sufficient condition is derived for the existence of a first‐best contract under this constraint, and a bonus‐based contract is shown to be the most efficient contractual form. Implications of bonus contracts are also discussed.

Limited Liability and Bonus Contracts

Limited Liability and Bonus Contracts

The prospective payment system, hospital efficiency, and compensation contracts for senior-level hospital administrators

This paper examines the effect of the change from a retrospective to a prospective regulatory procedure, for reimbursing Medicare costs, on the use of bonus-based compensation contracts for senior-level hospital administrators. For a large sample of hospitals from a national survey, our results suggest that hospitals which were relatively inefficient in the time period prior to the institution of the prospective payment system tended to use contracts with larger bonuses as a percentage of base salary in the time period after this regulatory change. That is, hospitals with a relative financial condition most adversely affected by the regulatory change seem to have used bonus contracts in an attempt to motivate the administrators to improve operating efficiency and performance. We also found that hospitals were less likely to use bonus-based compensation contracts if the hospital's activities were closely monitored (by the board of directors or by the state). This result is consistent with the agency theory notion that monitoring activities and bonuses can both be used as motivational devices.

The length of bonus contracts in Japanese manufacturing

This paper applies the theory of optimal contract length to Japanese bonus contracts. The main finding is that the variance of industry-related shocks and two measures of negotiation costs explain about half of the variation across industries and over time in the percentage of firms that set bonuses only once a year. The result suggests that one of the reasons why we observe large bonus payments in Japan is that they substitute for staggered wage negotiations.

Intended versus Actual Behavior: Results from the Air Force Aviation Bonus Program

To assess the validity of survey data collected from computer assisted telephone interviews (CATI) for the prediction of retention behavior, data from 754 AF pilots were collected at two points in time. In January 1988 these pilots took part in a CATI study that revealed their intentions to sign contracts for additional years of military service in return for bonus payments of up to $12,000 per year. Beginning in January 1989, these pilots were offered aviation bonus contracts, similar to those studied with the CATI, under the Aviator Continuation Pay (ACP) program enacted by Congress. Two key variables from the survey—career intent and bonus intent—were very accurate in predicting ACP behavior at both the aggregate and the entity levels.

The effect of bonus schemes on accounting decisions

Studies examining managerial accounting decisions postulate that executives rewarded by earnings-based bonuses select accounting procedures that increase their compensation. The empirical results of these studies are conflicting. This paper analyzes the format of typical bonus contracts, providing a more complete characterization of their accounting incentive effects than earlier studies. The test results suggest that (1) accrual policies of managers are related to income-reporting incentives of their bonus contracts, and (2) changes in accounting procedures by managers are associated with adoption or modification of their bonus plan.