On the Failures of Bonus Plans

TL;DR

This paper analyzes the strategic interactions between a decision maker and investment firms, proving the existence of an optimal bonus policy aligning firms' incentives with the DM's goals, and characterizing universally optimal policies.

Contribution

It establishes the existence of an optimal bonus policy that aligns firms' incentives with the decision maker's interests and characterizes policies that are universally optimal across markets.

Findings

Existence of an optimal bonus policy for the DM.

Optimal policies can motivate firms to act in the DM's interest.

Only policies independent of firms' actions are universally optimal.

Abstract

A decision maker (DM) has some funds invested through two investment firms. She wishes to allocate additional funds according to the firms' earnings. The DM, on the one hand, tries to maximize the total expected earnings, while the firms, on the other hand, try to maximize the overall expected funds they manage. In this paper we prove that, for every market, the DM has an optimal bonus policy such that the firms are motivated to act according to the interests of the DM. On the other hand, we also prove that the only policy that is optimal in every market, is independent of the actions and earnings of the firms.