Dynamic Bonus Pools

Abstract

We study the properties of long-term bonus pools with rollover provision in a multi-period moral hazard setting, where the principal uses subjective information to privately assess the agent’s performance and the agent is protected by limited liability. To provide incentives, the principal funds a multi-period bonus pool with a fixed payment that may be distributed over time to the agent and a third party. We find that the optimal long-term bonus-pool contract features performance targets that are contingent on past performance. Specifically, high subjective performance implies an easy target, and low subjective performance implies a difficult target. To implement the long-term bonus-pool contract, the principal provides non-dichotomous performance reports. The study contributes to the literature that discusses the mechanisms that make subjective performance information useful for incentive contracting.

Keywords: Bonus Pool, Dynamic Agency, Subjective Performance Evalution, Verifiability

JEL Classification: D82, M40, M52