Has Moral Hazard Become a More Important Factor in Managerial Compensation?

The theory of moral hazard predicts that since the activities of managers are hard to monitor directly, managerial compensation is tied to the profitability of the firms they manage. In this empirical study we investigate the hypothesis that the secular trends in managerial compensation can be attributed to the changing importance of moral hazard that affect the optimal contract through shifts in the distribution of the abnormal returns to the firm. We estimate a principal agent model of moral hazard controlling for heterogeneity across sectors, different measure of firm size, leverage, and executive position within the firm hierarchy. Our two data sets on three industrial sectors, which together span a sixty year period, strengthens past research that documents the increasing level of total executive compensation and the sensitivity of compensation to firm performance over the last two decades. Within each data set almost all variation in executive compensation is explained by the firms abnormal returns and the controls in our empirical model. We find that had moral hazard not been a factor, compensation in the three sectors would have increased at the same rate as national income, much lower than the average increase that actually occurred. We find little evidence to suggest that managerial tastes have changed, or that the nonpecuniary benefits to managers deviating from shareholder interests have increased. There are two factors driving the sharply increased costs of moral hazard. First, increased dispersion of abnormal returns has led to deterioration in the signal shareholders receive about managerial activities, raising the welfare costs of moral hazard in two sectors we investigate. Second, we find the changing composition of firms in all sectors has increased average firm size, and we find that managing larger firms increases the discrepancy between shareholder and managerial interests.