Dynamic Bonus Pools

Abstract

We study the properties of dynamic bonus pools with rollover provision in a multi-period agency setting, where the principal privately assesses her agent’s performance using subjective information and the agent is protected by limited liability. To provide incentives, the principal funds a 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 memory in the sense that the agent’s period-by-period incentives are contingent on past performance. Specifically, high subjective performance implies an easy future target, whereas low subjective performance implies a difficult target. To implement the long-term bonus-pool contract, the principal applies different criteria when subjectively evaluating the agent’s performance over time. Our 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