Performance Standards in Incentive Contracts

Research in incentives has focused on performance measures and pay-performance sensitivities but has largely ignored a third significant dimension: the performance standard. Performance standards generate important incentives whenever plan participants can influence the standard-setting process. I describe management bonus contracts and the role of performance standards, distinguishing between "internally determined" standards that are directly affected by management actions in the current or prior year, and "externally determined" standards that are less easily affected. I show that companies choose external standards when prior-year performance is a noisy estimate of contemporaneous performance. In addition, companies using budget-based and other internally determined performance standards have less-variable bonus payouts, and are more likely to smooth earnings from year to year, than companies using externally determined standards.