The Choice of Different Types of Subjectivity in CEO Annual Bonus Contracts

In assessing the performance of the CEO, subjectivity by the board of directors is often present in one form or another. We specifically focus on: (1) the ex ante option to ex post override a formula-based contract (“discretionary bonus”), and (2) the ex ante absence of any formula in a contract (“subjective weights”). We argue that the two types of deviations are driven by different contracting problems, which relate to whether post-contract information does or does not affect the agent’s optimal action choice. We refer to these different contracting problems as problems of risk and problems of noncongruity, respectively, and hypothesize that discretionary bonuses are used for risk reduction purposes, while subjective weights on different performance dimensions are used for congruity improvement purposes Our empirical results are consistent with our expectations, showing that the use of the different types of subjectivity is consistent with optimal contracting considerations.