You are not currently logged in.

Access your personal account or get JSTOR access through your library or other institution:


Log in to your personal account or through your institution.

Performance Thresholds in Managerial Incentive Contracts

Xianming Zhou and Peter L. Swan
The Journal of Business
Vol. 76, No. 4 (October 2003), pp. 665-696
DOI: 10.1086/377035
Stable URL:
Page Count: 32
Subjects: Business Finance
Find more content in these subjects: Business Finance
  • Download PDF
  • Add to My Lists
  • Cite this Item
We're having trouble loading this content. Download PDF instead.


Performance thresholds are commonly used in executive compensation contracts. We examine the contractual nonlinearity associated with performance thresholds and its incentive implications. Incorporating a performance threshold into a standard principal‐agent model of a linear contract, we show that pay schemes using a performance threshold are optimal. By truncating a linear scheme at poor performance, the threshold mitigates agency costs associated with the downside risk of production. Examining CEO compensation data, we find evidence of the role of performance thresholds. As a consequence of under‐threshold performance, the tobit estimator is shown to increase pay‐performance sensitivity, notably improving upon the standard OLS estimator.

Notes and References

This item contains 31 references.

  • ['Aggarwal, R. K., and Samwick, A. A. 1999a. The other side of the trade‐off: The impact of risk on executive compensation. Journal of Political Economy 107 (February): 65–105.']
  • ['Aggarwal, R. K., and Samwick, A. A. 1999b. Performance incentives within firms: The effect of managerial responsibility. Working paper. Cambridge, Mass.: National Bureau of Economic Research.']
  • ['Bryant, S.; Hwang, L.; and Lilien, S. 2000. CEO stock‐based compensation: An empirical analysis of incentive‐intensity, relative mix, and economic determinants. Journal of Business 73 (October): 661–94.']
  • ['Core, J., and Guay, W. 1999. The use of equity grants to manage optimal equity incentive levels. Journal of Accounting and Economics 28 (December): 151–84.']
  • ['Garen, J. E. 1994. Executive compensation and principal‐agent theory. Journal of Political Economy 102 (December): 1175–99.']
  • ['Gibbons, R. 1997. Incentives and careers in organizations. Working paper. Ithaca, N.Y., and Cambridge, Mass.: Cornell University and National Bureau of Economic Research.']
  • ['Gibbons, R., and Murphy, K. J. 1992. Optimal incentive contracts in the presence of career concerns: Theory and evidence. Journal of Political Economy 100 (June): 468–505.']
  • ['Gjesdal, F. 1988. Piecewise linear incentive schemes. Scandinavian Journal of Economics 90(3):305–28.']
  • ['Grossman, S., and Hart, O. 1983. An analysis of the principal‐agent problem. Econometrica 51 (January): 7–45.']
  • ['Hall, B. J., and Liebman, J. B. 1998. Are CEOs really paid like bureaucrats? Quarterly Journal of Economics 113 (August): 653–91.']
  • ['Haubrich, J. G. 1994. Risk aversion, performance pay, and the principal‐agent problem. Journal of Political Economy 102 (April): 258–76.']
  • ['Holmstrom, B. 1979. Moral hazard and observability. Bell Journal of Economics 10 (Spring): 74–91.']
  • ['Holmstrom, B. 1982. Design of incentive schemes and the new Soviet incentive model. European Economic Review 17 (January): 127–48.']
  • ['Holmstrom, B., and Milgrom, P. 1987. Aggregation and linearity in the provision of intertemporal incentives. Econometrica 55 (March): 303–28.']
  • ['Hubbard, R. G., and Palia, D. 1995. Executive pay and performance: Evidence from the U.S. banking industry. Journal of Financial Economics 39 (September): 105–30.']
  • ['Jensen, M. C., and Murphy, K. J. 1990. Performance pay and top‐management incentives. Journal of Political Economy 98 (April): 225–64.']
  • ['John, T. A., and John, K. 1993. Top management compensation and capital structure. Journal of Finance 48 (July): 949–74.']
  • ['Joskow, P.; Rose, N.; and Shepard, A. 1993. Regulatory constraints on CEO compensation. Brookings Papers on Economic Activity: Microeconomics, no. 1, pp. 1–58.']
  • ['Kole, S. R. 1997. The complexity of compensation contracts. Journal of Financial Economics 43 (January): 79–104.']
  • ['Lambert, R., and Larcker, D. 1987. An analysis of the use of accounting and market measures of performance in executive compensation contracts. Journal of Accounting Research 25, suppl.:85–129.']
  • ['Lambert, R., and Larcker, D. 1991. Executive compensation, corporate decision making, and shareholder wealth: A review of the evidence. In F. K. Foulkes (ed.), Executive Compensation. Cambridge, Mass.: Harvard Business School Press.']
  • ['Mirrlees, J. 1974. Notes on welfare economics, information, and uncertainty. In M. Balch, D. McFadden, and S. Wu (eds.), Essays on Economic Behavior under Uncertainty. Amsterdam: North Holland.']
  • ['Mirrlees, J. 1979. The implication of moral hazard for optimal insurance. Mimeographed. Seminar given at conference held in honor of Karl Borch, Bergen, Norway.']
  • ['Murphy, K. J. 1999. Executive compensation. In O. Ashenfelter and D. Card (eds.), Handbook of Labor Economics, vol. 3. Armsterdam: North Holland.']
  • ['Murphy, K. J. 2001. Performance standards in incentive contracts. Journal of Accounting and Economics 30 (December): 245–78.']
  • ['Rogerson, W. P. 1985. The first‐order approach to principal‐agent problems. Econometrica 53 (November): 1357–67.']
  • ['Rosen, S. 1992. Contracts and the market for executives. In L. Werin and H. Wijkander (eds.), Contract Economics. Oxford: Blackwell.']
  • ['Schaefer, S. 1998. The dependence of CEO pay‐performance sensitivity on the value of the firm. Review of Economics and Statistics 80 (August): 436–43.']
  • ['Sloan, R. 1993. Accounting earnings and top executive compensation. Journal of Accounting and Economics 16 (January/April/July): 55–100.']
  • ['Smith, C. W., Jr., and Watts, R. 1992. The investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Financial Economics 32 (December): 263–92.']
  • ['Weitzman, M. L. 1976. The new Soviet incentive model. Bell Journal of Economics and Management Sciences 7 (Spring): 251–57.']