The Incentive Effects of Performance Measures and Target Setting.

Abstract

Lavish executive compensation packages, and bonuses awarded to executives by financial institutions that only just received government bailouts, have fueled the currently popular perception that compensation is primarily determined by powerful managers granting themselves excessive compensation tenuously related with performance. This thesis challenges the widespread public notion that managerial power represents the primary determinant of compensation design by examining to what extent choices about performance measures, targets, and incentives are informed by agency theory. The first essay uses data from a firm’s general ledger to examine how this firm updates sales targets and how managers respond to this process. I document that the firm uses current sales performance (i.e. target ratcheting) and information from subjective appraisals to set nextperiod targets that challenge each manager in his or her own right. Despite the firm’s effort to limit managers’ ability to manipulate performance, I document adverse consequences of target ratcheting, i.e. managers who perform well slow down performance at the end of the year to mitigate target updates. The second essay examines investigates whether CEOs appointed from outside the firm are provided with different incentives than CEO successors selected from within the firm to address potential distortions in intertemporal decisionmaking. Outside successors are allegedly prone to short-termism due to their greater outside employment options and their inclination to focus on ‘quick wins’ to swiftly build reputation. I document that firms aim to lengthen the horizon of outside successors by de-emphasizing bonuses (contingent on current earnings) and emphasizing long-term compensation (contingent on future earnings and/or stock price). The third essay examines whether firms provide optimally weak incentives when they lack undistorted performance measures. I argue that firms that use nonfinancials together with summary financial measures in CEO bonus plans do not completely alleviate the congruence problems that would originate from a sole reliance on financials. I document that firms that increase incentives reduce the weight on nonfinancials in their CEO bonus plans.