The Relative Performance Puzzle

Abstract

The accepted theoretical models of executive compensation contracts all seem to imply that optimal remuneration packages should contain a relative performance element. The puzzle is that the empirical literature has found remarkably little relative performance evaluation. This paper aims at resolving this puzzle by introducing the notion that the manager can trade on assets other than her own company's stock. Then the manager's portfolio strategy always adjusts for the risks of her compensation contract and she replaces the firm's benchmark with a - home-made - benchmark. She chooses exactly the weights and the compensation of the benchmark that would otherwise be chosen in an optimal contract. In many cases this is possible without short selling any assets. To the extent that performance benchmarks are correlated with traded assets they are redundant for the optimal contract. Accounting benchmarks are exempt from this verdict since they may help to insure the manager against risks that are not related to traded assets. This may help to understand the presence of relative performance elements in annual bonus plans.

Keywords: Executive Compensation

JEL Classification: G30, M52