Career Concerns And The Optimal Pay-for-Performance Sensitivity

Prior literature suggests that managers’ career concerns provide implicit incentive mechanisms for their behaviors (Fama (1980), Holmstrom (1999)), and may substitute the explicit incentives in their compensation contracts (Gibbons and Murphy (1992)). We show that the substitution effect can be weakened, and even reversed, when managers perform multiple tasks and are concerned about both the level and variability of their reputation. We also find that after taking into consideration managers’ concerns for the variability of their reputation, the optimal pay-for-performance sensitivity can also be increasing in the underlying risk measure. We test these predictions using a large sample of chief executive officers’ compensations over 1993-2003; results are consistent with our model predictions. (JEL: J31; J41; D80) ∗The Fuqua School of Business, Duke University, Durham, NC 27708, email: [email protected]; Columbia Business School, New York, NY 10027, email: [email protected]. We received helpful comments from Jim Anton, Robert Bushman, Harry Evans, Jennifer Francis, Itay Goldstein, Thomas Hemmer, Steve Kaplan, Young Kwon, Tracy Lewis, Mike Riordan, and workshop participants at University of California — Berkeley and HKUST. We are responsible for all remaining errors. The research was supported by the Fuqua School of Business, Duke University and the Eugene Lang Center of Entrepreneurialship, Columbia Business School.