Essays on behavioral aspects of the design and disclosure of compensation contracts

This thesis consists of four essays on the design and disclosure of compensation contracts. Essays 1, 2 and 3 focus on behavioral aspects of mandatory compensation disclosure rules and of contract negotiations in agency relationships. The three experimental studies develop psychology- based theory and present results that deviate from standard economic predictions. Furthermore, the results of Essay 1 and 2 also have implications for firms’ discretion in how to communicate their top management’s incentives to the capital market. Essay 4 analyzes the role of fairness perceptions for the evaluation of executive compensation. For this purpose, two surveys targeting representative eligible voters as well as investment professionals were conducted. Essay 1 investigates the role of the detailed ‘Compensation Discussion and Analysis’, which is part of the Security and Exchange Commission’s 2006 regulation, on investors’ evaluations of executive performance. Compensation disclosure complying with this regulation clarifies the relationship between realized reported compensation and the underlying performance measures and their target achievement levels. The experimental findings suggest that the salient presentation of executives’ incentives inherent in the ‘Compensation Discussion and Analysis’ makes investors’ performance evaluations less outcome dependent. Therefore, investors’ judgment and investment decisions might be less affected by noisy environmental factors that drive financial performance. The results also suggest that fairness perceptions of compensation contracts are essential for investors’ performance evaluations in that more transparent disclosure increases the perceived fairness of compensation and the performance evaluation of managers who are not responsible for a bad financial performance. These results have important practical implications as firms might choose to communicate their top management’s incentive compensation more transparently in order to benefit from less volatile expectations about their future performance. Similar to the first experiment, the experiment described in Essay 2 addresses the question of more transparent compensation disclosure. However, other than the first experiment, the second experiment does not analyze the effect of a more salient presentation of contract information but the informational effect of contract information itself. For this purpose, the experiment tests two conditions in which the assessment of the compensation contracts’ incentive compatibility, which determines executive effort, is either possible or not. On the one hand, the results suggest that the quality of investors’ expectations about executive effort is improved, but on the other hand investors might over-adjust their prior expectations about executive effort if being confronted with an unexpected financial performance and under-adjust if the financial performance confirms their prior expectations. Therefore, in the experiment, more transparent compensation disclosure does not lead to more correct overall judgments of executive effort and to even lower processing quality of outcome information. These results add to the literature on disclosure which predominantly advocates more transparency. The findings of the experiment however, identify decreased information processing quality as a relevant disclosure cost category. Firms might therefore carefully evaluate the additional costs and benefits of more transparent compensation disclosure. Together with the results from the experiment in Essay 1, the two experiments on compensation disclosure imply that firms should rather focus on their discretion how to present their compensation disclosure to benefit from investors’ improved fairness perceptions and their spill-over on performance evaluation. Essay 3 studies the behavioral effects of contextual factors in recruitment processes that do not affect the employer’s or the applicant’s bargaining power from a standard economic perspective. In particular, the experiment studies two common characteristics of recruitment processes: Pre-contractual competition among job applicants and job applicants’ non-binding effort announcements as they might be made during job interviews. Despite the standard economic irrelevance of these factors, the experiment develops theory regarding the behavioral effects on employees’ subsequent effort provision and the employers’ contract design choices. The experimental findings largely support the predictions. More specifically, the results suggest that firms can benefit from increased effort and, therefore, may generate higher profits. Further, firms may seize a larger share of the employment relationship’s profit by highlighting the competitive aspects of the recruitment process and by requiring applicants to make announcements about their future effort. Finally, Essay 4 studies the role of fairness perceptions for the public evaluation of executive compensation. Although economic criteria for the design of incentive compensation generally do not make restrictive recommendations with regard to the amount of compensation, fairness perceptions might be relevant from the perspective of firms and standard setters. This is because behavioral theory has identified fairness as an important determinant of individuals’ judgment and decisions. However, although fairness concerns about executive compensation are often stated in the popular media and even in the literature, evidence on the meaning of fairness in the context of executive compensation is scarce and ambiguous. In order to inform practitioners and standard setters whether fairness concerns are exclusive to non-professionals or relevant for investment professionals as well, the two surveys presented in Essay 4 aim to find commonalities in the opinions of representative eligible voters and investments professionals. The results suggest that fairness is an important criterion for both groups. Especially, exposure to risk in the form of the variable compensation share is an important criterion shared by both groups. The higher the assumed variable share, the higher is the compensation amount to be perceived as fair. However, to a large extent, opinions on executive compensation depend on personality characteristics, and to some extent, investment professionals’ perceptions deviate systematically from those of non-professionals. The findings imply that firms might benefit from emphasizing the riskiness of their managers’ variable pay components and, therefore, the findings are also in line with those of Essay 1.

A conceptual model of compensation/decompensation in lumbar segmental instability

Lumbar spinal instability (LSI) is a common spinal disorder and can be associated with substantial disability. The concept of defining clinically relevant classifications of disease or 'target condition' is used in diagnostic research. Applying this concept to LSI we hypothesize that a set of clinical and radiological criteria can be developed to identify patients with this target condition who are at high risk of 'irreversible' decompensated LSI for whom surgery becomes the treatment of choice. In LSI, structural deterioration of the lumbar disc initiates a degenerative cascade of segmental instability. Over time, radiographic signs become visible: traction spurs, facet joint degeneration, misalignment, stenosis, olisthesis and de novo scoliosis. Ligaments, joint capsules, local and distant musculature are the functional elements of the lumbar motion segment. Influenced by non-functional factors, these functional elements allow a compensation of degeneration of the motion segment. Compensation may happen on each step of the degenerative cascade but cannot reverse it. However, compensation of LSI may lead to an alleviation or resolution of clinical symptoms. In return, the target condition of decompensation of LSI may cause the new occurrence of symptoms and pain. Functional compensation and decompensation are subject to numerous factors that can change which makes estimation of an individual's long-term prognosis difficult. Compensation and decompensation may influence radiographic signs of degeneration, e.g. the degree of misalignment and segmental angulation caused by LSI is influenced by the tonus of the local musculature. This conceptual model of compensation/decompensation may help solve the debate on functional and psychosocial factors that influence low back pain and to establish a new definition of non-specific low back pain. Individual differences of identical structural disorders could be explained by compensated or decompensated LSI leading to changes in clinical symptoms and pain. Future spine surgery will have to carefully define and measure functional aspects of LSI, e.g. to identify a point of no return where multidisciplinary interventions do not allow a re-compensation and surgery becomes the treatment of choice.

Horn Growth and Reproduction in a Long-Lived Male Mammal: No Compensation for Poor Early-Life Horn Growth

Secondary sexual traits in males of polygynous species are important determinants of reproductive success. It is, however, unknown if and how the development of continuously growing traits at different life-stages is related to reproduction in long-lived male mammals. In this study, we evaluated the relationship of early and late horn growth on social status and reproduction in long-lived male Alpine ibex (Capra ibex). For this, we analysed individual horn growth and assessed its effect on dominance and reproduction. No evidence was detected for compensatory horn growth, as late-life horn growth positively depended on early-life horn growth in males. Still, individuals with longer horn segments grown during early adulthood experienced a stronger age-dependent length decline in annual horn growth during the late development. Accordingly, a divergence between individual growth potential and realized horn growth late in life has to be assumed. Residual age-specific horn length and length of early grown horn segments both positively affected dominance and reproductive success, whereas, contrary to our expectation, no significant effect of the length of horn segments grown during the late development was detected. Suspected higher somatic costs incurred by high-quality males during their late development might at least partly be responsible for this finding. Overall, our study suggests that the total length of horns and their early development in long-lived male Alpine ibex is a reliable indicator of reproductive success and that individuals may be unable to compensate for poor early-life growth performance at a later point in life.