Private Predecision Information and the Pay-Performance Relation

We study how the precision of managers’ private post-contract predecision information affects the pay-performance relation. Taking into account that the information environment in decentralized firms is often endogenously determined (e.g., by investment in internal accounting systems, hiring of consultants, or learning), we find that firms jointly choosing information precision and incentives may optimally tie executive pay closer to firm performance as agency problems become more pronounced. Specifically, the trade-off between information precision and incentives can render it optimal to provide agents with stronger incentives if agents are less productive, performance measures are less congruent or more susceptible to manipulation, or if agents are more risk averse. Considering that empirical studies frequently take the pay-performance sensitivity (PPS) as a measure of the efficiency of real world compensation arrangements, our results provide relevant insights for empirical research studying the determinants of the relation between executive pay and firm performance. Keywords: incentive contracting, predecision information, information design, pay-performance relatio