Executive Bonus Convexity and Target Ratcheting

Revising targets based on past performance may give managers perverse incentives to withhold effort (i.e., the ratchet effect). This study investigates whether convex executive bonus compensation mitigates this adverse incentive effect. Using a subset of S&P 1500 firms that take EPS as a performance measure for their executives’ annual bonus compensation, I find that convex bonus payouts mitigate managerial effort reduction. I also find that the mitigating effect is less significant when 1) firms just experienced CEO retirement, and 2) firms use intense intensity in terms of the bonus function’s slope. Firms with a higher level of information asymmetry and operating in a more competitive industry are more likely to provide convex bonus plans to their CEOs. Lastly, I document a complementary relation between bonus convexity and equity convexity in boosting managerial efforts.