Managerial labour markets undoubtedly reduce the severity of moral hazard.

However, past
manager performance is not an iron-clad indicator of future performance. Also, labour markets are
subject to adverse selection problems such as earnings management to disguise shirking. Consequently,
incentive contracts are still necessary even if managers’ reputations on managerial labour markets fully
reflect publicly available information.

Executive compensation contracts involve a delicate balancing of incentives, risk, and decision
horizon. To properly align the interests of managers and shareholders, an efficient contract needs to
achieve a high level of motivation while controlling compensation risk. Too little risk discourages
manager effort. Too much risk may shorten a manager’s decision horizon, encourage earnings-
increasing tactics that are against the firm’s longer-run interests, lead to avoidance of risky projects, and
encourage excessive hedging. Managers are particularly sensitive to risk, because the compensation
contract may restrict their ability to diversify it away, unlike shareholders.

To attain proper alignment, incentive plans usually feature a combination of salary, bonus,
equity-based compensation such as restricted stock and options, and golden parachutes. These
components of compensation are usually based on several performance measures—individual
achievement, net income, and share price. We can think of these as noisy measures of the future payoff
from current-period manager effort. Theory predicts that the relative proportion of each in the
compensation plan depends on both their relative precision and sensitivity, and the length of manager
decision horizon that the firm wants to motivate. Empirically, it appears that executive compensation is
related to performance, although there is evidence suggesting that the strength of the relationship is
low. However, for large firms at least, this low relationship is to be expected. Also, the relative
proportion of net income-based and share price-based compensation components seems to vary as the
theory predicts.

Executive compensation is surrounded by political controversy. Much of this controversy results

from CEOs who exploit their power, using it to generate excessive compensation. Regulators have
responded by expanding the information available to shareholders and others, on the assumption that
they will take action to eliminate inefficient plans, or the managers and firms that have them. There is
some evidence that expanded information is having the desired effect. However, politicians, media, and
shareholders should realize that the utility of risky compensation to risk-averse managers may be less
than it seems at first glance.

We conclude that financial reporting has an important role in motivating executive performance
and controlling manager power. This role includes full disclosure, so that compensation committees and
investors can better relate pay to performance. It also includes expensing stock option awards to help
control their abuse and encourage more efficient compensation vehicles. As a result, responsible
manager performance is motivated and the extent to which manager reputation is based on incomplete
or biased information is reduced. This improves the operation of the managerial labour market, a goal
equally important to society as promoting good investor decisions and improving the operation of
securities markets.