Dynamic Managerial Compensation: a Mechanism Design Approach

We characterize the optimal incentive scheme for a manager who faces costly effort decisions and whose ability to generate profits for the firm varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent's productivity. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the firm's profits. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justification for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the firm. In contrast to other explanations proposed in the literature (e.g., declining disutility of effort or career concerns), the optimality of seniority-based reward schemes is not driven by variations in the agent's preferences or in his outside option. It results from an optimal allocation of the manager's informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. We find that, other things equal, risk-aversion reduces the benefit of inducing higher effort over time. Whether (risk-averse) managers with a longer tenure receive more or less high-powered incentives than younger ones then depends on the interaction between the degree of risk aversion and the dynamics of the impulse responses for the shocks to the manager's type.