Cost Shielding in Executive Bonus Plans

Abstract

Executive bonus plans often incorporate performance measures that disregard certain costs — a phenomenon we refer to as “cost shielding.” We develop measures of cost shielding and examine whether boards use cost shielding to alleviate agency conflicts between executives and shareholders. Consistent with predictions from agency theory, we find that boards select performance measures to shield executives from costs that are (i) incurred prior to their associated benefits, or (ii) the result of previous executives’ actions. We also find that many of these patterns are more pronounced among firms with more financial expertise on the board. Collectively, our results provide evidence that boards use cost shielding in executive bonus plans in response to potential agency conflicts and suggest that directors’ financial expertise facilitates incentive-compensation contracting efficiency.

Keywords: executive compensation, cost shielding, managerial incentives, performance measurement, bonus contracts, agency theory

JEL Classification: G34, J3, M12