Cost Shielding in Executive Bonus Plans

Abstract

Executive bonus plans often incorporate performance measures that exclude particular costs—a practice we refer to as “cost shielding.” Based on an agency theoretic framework, we predict that boards use cost shielding to (i) mitigate managerial myopia and (ii) encourage newer executives to disregard sunk costs associated with prior executives’ actions. Consistent with our first prediction, we find evidence that boards use cost shielding to deter myopic underinvestment in intangibles and encourage managers to take advantage of growth opportunities. Consistent with our second prediction, we find that boards tend to shield newly hired executives from costs arising from prior executives’ decisions, and this cost shielding diminishes over the course of executives’ tenure. Collectively, our results provide insight into the purpose of bonus plans and are consistent with the notion that boards deliberately choose performance metrics that alleviate agency conflicts.