Discretion in Managerial Bonus Pools

It is common practice for firms in a variety of industries to specify bonus pools that are available for distribution among a group of managers. While the actual size of the bonus pool may vary with the realization of certain financial metrics, for example, earnings growth or Return-on-Investment, the essential property of bonus pools is that the firm retains discretion in how the overall pool is divided among the target group of managers. An important advantage of discretionary bonus payments is that the persons in charge of administering the bonus pool are in a position to incorporate subjective, non-verifiable indicators of individual performance that would be impossible to specify contractually as part of an explicit incentive scheme. This paper synthesizes several strands of the recent principal-agent literature that have explored the structure and the relative efficiency of discretionary bonus pools. Our analysis is framed around a number of recurring themes. These include the value of subjective performance indicators for contracting purposes, the loss associated with subjective rather than objective information, and finally, the degree to which bonus pools entail more compression in the amounts of bonuses paid to managers.