Managerial Compensation: Linear-Sharing vs. Bonus-Incentive Plans Under Moral Hazard and Adverse Selection

Abstract

In the fall of 1978, with the Chrysler Corporation perilously close to bankruptcy, Lee Iaccoca accepted the difficult job of running the corporation with an annual salary of $360,000, options to buy 400,000 shares of Chrysler common stock at $11 each, plus special payments amounting to more than a million dollars.¹ Next summer, he volunteered to reduce his base salary to $1.00 for a period of one year.² Although this may not be a typical example, it is nonetheless illustrative of the nature of incentive compensation plans at the senior management level. “Successful” senior managers are extremely highly paid. Fox and Peck(1985) report the median total compensation of chief executive officers in large manufacturing firms to be $442,000.^{3, 4} Although the variation seems to be large, all the figures contained in this report are in the six-digit range. It is readily apparent that both level and composition of top executive compensation packages is different from that of workers in other occupations. Particularly notable is the recent trend toward paying a substantial portion of the total compensation in the form of incentive plans, such as annual bonus, long-term performance reward, stock options, and restricted stocks.⁵ Most (92%) of the manufacturing firms in the Fox-Peck survey used annual bonus plans for their senior executives in 1984; 88% of these actually paid bonuses.

An earlier version of this paper was presented in seminars at UBC, UC-Berkeley, UCLA, Columbia, Davis, Minnesota, NYU, Northwestern and the 1984 summer meetings of the Econometric society. We are grateful for comments from the participants, in particular Michael Whinston. We would also like to thank Jerry Feltham for his numerous helpful suggestions. Stoughton’s research is partially supported by Grant 410–83–0786 R-1 provided by the Social Sciences and Humanities Research Council of Canada.