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 fim 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 private information. 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. Contrary to other explanations proposed in the literature (e.g. declining disutility of effort, learning by doing, career concerns), the optimality of seniority-based reward schemes is not driven by any particular assumption on the agent's preferences/technology. 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. Contrary to the risk-neutral case, the optimal pay package is typically non-linear in the firm's profits (although, there are instances where it is convex function of a linear aggregator). Furthermore, we find that risk-aversion may reduce (but not necessarily eliminate) the benefit of offering incentives whose power increase, on average, over time.