Accounting for Net Performance in Managerial Compensation Contracts
42 Pages Posted: 17 Aug 2011 Last revised: 6 Mar 2012
Date Written: March 5, 2012
Prior empirical compensation studies typically consider net performance (i.e., measured after deducting compensation) while related principal-agent theory is generally based on gross performance measures (i.e., before compensation). We analyze incentive rates in a principal-agent model based on net (and gross) performance. We analytically demonstrate that using gross performance in compensation regressions yields an unbiased estimate of total effort incentives irrespective of whether actual compensation is based on net or gross performance. In contrast, using net performance creates a bias in estimating total effort incentives and yields a non-zero benchmark in testing for the strong-form relative performance evaluation hypothesis. We provide empirical evidence of underestimated total effort incentives when using net performance in compensation regressions, suggesting a possible explanation for surprisingly weak CEO incentives interpreted in prior studies.
Keywords: Executive Compensation, Relative Performance Evaluation, Performance Measurement
JEL Classification: J33, M40, M46
Suggested Citation: Suggested Citation