Discretion in Managerial Bonus Pools

* We are grateful to Ulf Schiller for helpful comments on an earlier version of this paper. We also thank Yanruo Wang for excellent research assistance. Agency theory has for most part focused on the nature and efficiency properties of " complete " incentive contracts. Accordingly, a contract is viewed as a collection of " if-then " statements such that a specific payoff results if a particular outcome has emerged. The enforceability of such incentive contracts is usually based on the notion that the outcomes are verifiable to third parties, with the consequence that a court of law could enforce the contract provisions in case of dispute. An essential characteristic of the incentive plans observed in many organizations is that they are not " hard-wired " but instead leave a considerable amount of discretion. Top-level management frequently defines a set of performance metrics and specifies certain boundary parameters for incentive compensation. Yet, at the same time management retains discretion in determining the actual rewards and compensation payments for lower level managers. The widespread use of balanced scorecards provides an illustration of discretionary performance measurement. Such scorecards usually combine a host of financial and non-financial performance indicators. 2 While firms make a commitment to measuring these variables for the purpose of performance evaluation, the actual aggregation (balancing) of the component variables for the purpose of determining managerial bonuses is frequently not specified contractually. Bonus pools provide another illustration of discretionary incentive mechanisms. It is common practice in firms across a variety of industries to specify an overall bonus amount for a group of managers. While this amount frequently varies with certain high-level financial metrics, like earnings, sales revenues or return on investment (ROI), the central feature of bonus pools is that the principal (board of directors or higher-level management) retains discretion for distributing the bonus pool among the eligible agents. Some publicly traded companies disclose considerable details about the structure of their bonus pool arrangements. The following excerpt is taken from the 2007 proxy statement of Aetna corporation: ". .. The Compensation Committee, after consulting with the Board, establishes specific financial and operational goals at the beginning of each performance year, and annual bonus funding is linked directly to the achievement of these annual goals. [.. . ] For 2007, bonus pool funding under the ABP [Annual Bonus Program] depended upon performance against the following measures: Financial performance (55%), health cost …