Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence

Abstract

This paper studies career concerns-concerns about the effects of current performance on future compensation-and describes how optimal incentive contracts are affected when career concerns are taken into account. Career concerns arise frequently: they occur whenever the market uses a worker's current output to update its belief about the worker's ability and competition then forces future wages (or wage contracts) to reflect these updated beliefs. Career concerns are stronger when a worker is further from retirement, because a longer prospective career increases the return to changing the market's belief.In the presence of career concerns, the optimal compensation contract optimizes total incentives-the combination of the implicit incentives from career concerns and the explicit incentives from the compensation contract. Thus, the explicit incentives from the optimal compensation contract should be strongest when a worker is close to retirement We find empirical support for this prediction in the relation between chief-executive compensation and stock-market performance.

Repeated moral hazard with persistence

“…Empirical evidence supports the main implication of our analysis: pay-forperformance elasticity is lower for younger CEOs (Gibbons and Murphy, 1992) and younger venture capital organizations (Gompers and Lerner, 1999). One interesting application would be to look at the pay-for-performance relationship for a more diverse worker pool and to test our prediction.…”

“…Gibbons and Murphy (1992) present evidence of contractual relationships where the structure of the variation in wages follows the predicted pattern. They show that the payfor-performance elasticity is lower for recently-appointed chief executive officers (CEOs) and that it increases as the CEOs approach retirement.…”

Inside Agency: The Rise and Fall of Nortel

“…Agency theorists argue that firms can mitigate both the adverse selection problem (Fama, 1980;Gibbons and Murphy, 1992), and the moral hazard problem (Lambert, 1983;Murphy, 1986;Rogerson, 1985), by tying the agent's compensation to firm performance. Managerial incentives may not be in the best interests of owners' calls for intelligently designed compensation structures.…”

Corporate Governance and Investment Decisions

“…While Dechow and Sloan (1991) show that CEOs approaching the end of their careers spend less on research and development (R&D) in order to increase their immediate accounting performance-based compensation, the results derived by Gibbons and Murphy (1992) suggest that managers approaching retirement do not necessarily decline to undertake long-term profitable investment projects. Bizjak, Brickley, and Coles (1993) find that when information asymmetry is high, a compensation contract with extreme emphasis on the current stock price may lead to overinvestment or underinvestment.…”