Managerial compensation, and their year to year change in wealth, varies significantly with the excess return on their firms stock. The positive correlation is primarily driven by the fact that managers hold stocks and options in their own firms. A large body of nonstructural empirical work has investigated how well managerial compensation can be rationalized by moral hazard.
As the dominant paradigm for explaining executive compensation, the theory of moral hazard postulates that risk averse managers are paid compensation that fluctuates with signals shareholders observe about decisions their managers make, notably excess returns of the firm, in order to align the incentives of the managers when their non pecuniary goals differ from maximizing shareholder wealth and the actions and decision of management are not monitored by shareholders. A growing number of papers on structural estimation have sort to quantify the economic significance of moral hazard in the labor market.
Applying the theory of moral hazard to explain managerial compensation has been challenged on several fronts. First, managers are paid for luck, risk factors beyond executive control that increase the volatility of their income, which is inconsistent with the notion of mitigating uncertainty in compensation to risk averse agents. Second, several empirical studies find that trading by corporate insiders appears profitable, but in models of puremoral hazard, managers do not have private information about the firms future prospects. Third, managerial compensation not only depends on the financial returns of the firm, but also its accounting returns. In models of pure moral hazard, shareholders might use signals other than financial returns to determine optimal compensation, but the reporting of accounting income is subject to considerable discretion by the manager.
The findings in the second paragraph cannot be easily explained by a pure moral hazard model where shareholders maximize the expected value of the firm. Yet compensation boards representing shareholders can and do exercise considerable discretion in setting executive pay. Thus the boards could ignore accounting income when compensating the manager, and they could retrospectively neutralize any returns managers receive from owning or trading financial securities related to the firm. Is it reasonable to assume that the only two constraints facing compensation boards arise from possibly losing the manager to another firm, or not being able to monitor the managers actions?
We argue in this paper that compensation boards are also constrained because they have less information about the state of the firm as the manager. We reconcile the correlations between managerial compensation and accounting and financial measures of firm returns with an optimal contracting model, where there is both hidden action and hidden information. We derive the restrictions from the model on data of periodic reports by the manager about the firms future prospects, excess returns by firms and managerial compensation. We demonstrate which data generating processes can be rationalized by the models we consider, and in that way establish set identification. Taking our framework to a large panel data set on the compensation of chief executive or cers and the firms they manage, we test whether hidden information is present or not, and assess its importance relative to pure moral hazard.
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