Discretion in Executive Incentive Contracts: Theory and Evidence

We examine the role of discretion in executive incentive contracts, and explore the trade-offs firms face in choosing among imperfect objective measures of individual performance, potentially more accurate but non-verifiable subjective measures, and overly broad objective measures of company-wide performance that include the performance of all agents in the firm. We generate implications and test the model empirically using a proprietary dataset of executive bonus plans. Consistent with our model, we find that discretion is less important in determining CEO pay than the pay of other executives. We also find that discretion is relatively important in determining executive bonuses at larger and privately held firms and that more diversified firms are relatively less likely to compensate their business unit managers based on firm-wide performance. Finally, we consider (and largely dismiss) tax-related explanations for our results.