Performance bonus pay: The carrot and the stick of salaried employment

Happiness and wealth: The peculiar case of men and women self-employed
23rd February 2019

Performance bonus pay: The carrot and the stick of salaried employment

The payment of a performance bonus can be a good way to motivate good employee performance than paying a fixed salary. The variable wage system has become an important element for modern day businesses to operate efficiently. However, it might be the case that it is more relevant for some industries than others. For instance, it may be rather important for businesses operating in dynamic environments, where there is a high need for individual decision making and creativity, than in more static ones. Additionally, firms may reward top performers with bonus pay rather than an increase in their salary or a promotion.

The tricky part of a performance bonus is hidden in the title; performance. Performance can be measured in many different ways, such as, sales, profit, return on assets, and then all the above can be assessed before tax or after, before interest, depreciation, etc. Moreover, in some trades it is far easier to measure performance than in others. For example, it is rather easy to measure performance in sales. The more the merrier. It is also easy for a salesperson to check how they are doing and adjust their performance to meet the goals to qualify for a bonus. But it may not be so straight forward for people who work as part of a team, or those who are in a decision making level. These types of performance can be harder to quantify.
"Bonuses, like other forms of performance pay, represent a means to mitigate agency problems in labor contracts. Payment contingent on worker performance stands in lieu of some portion of an otherwise riskless salary payment and serves to increase firm profitability, worker utility, or both."

Colin Green and John Heywood

The problems with performance based pay though do not stop here. Behind the incentive to solve essentially what is called the principal - agent problem, companies have substituted the fixed salary, in various proportion, with performance based compensation. Theoretically, when the performance based pay is provided as extra incentive for doing a better job and working more efficiently then it is beneficial for both the company and the employees. However, when the fixed salary is fully absent or minimal to the point where essential modern life provisions are not guaranteed, then it is problematic.

Furthermore, the last financial crisis revealed that top managers in failing commercial banks were receiving large bonuses even while the business was going bankrupt and a great number of lower level employees were being fired. Proponents of performance bonus pay as incentive for superior performance claim that any reduction in bonus payments schemes will lead to a loss of talent, since high performance employees will tend to concentrate in industries employing such pay schemes. However, empirical evidence suggests that top managers are likely to “skim” rents from their companies in ways that are hard to detect, since it is top managers who determine both their own contracts and those of their employees (Bertrand and Mullanaithan, 2001). Of course, sometimes extra pay may be "baptised" performance bonus, when it is actually more of a "retainment bribe" (e.g. failing companies that attempt to retain fleeing personnel).

"Since the skimming view emphasizes the CEO's ability to gain control of the pay process, corporate governance should play an important role in skimming. It is exactly in the poorly governed firms where we expect CEOs to most easily gain control of the pay process."

Marianne Bertrand And Sendhil Mullainathan

Empirical studies indicate that performance bonus pay substitution for fixed pay is very large at the bottom of the earnings distribution, while at the very top of the earnings distribution the evidence of substitution tends to disappear (Green and Heywood, 2016). Essentially, top managers are receiving large bonuses on top of large fixed salaries when they are in poorly managed companies. A rather paradoxical, counter intuitive and bottom line inefficient outcome. It can also be quite morally defeating for the lower level employees and managers, who might feel distressed about it and that their hard work is not appreciated in such a business environment.

The performance bonus incentives do not account for extra income for the significant majority of wage-employees, but is actually a real life application of "the carrot and the stick". Moreover, the substitution of a fixed salary increase based on merit or a promotion reward, is hijacked using a performance bonus pay. This way firms are free to appoint managers for reasons not related with superior performance (Benson, Li and Shue, 2018). It is not surprising that a significant number of people who start their own businesses often cite reasons related to dissatisfaction with previous work arrangements among other reasons.

Lastly, there are also indications of gender differences in the compensations of wage-employed men and women due to unequal payout of performance bonuses. The gender pay gap in fixed salary payment has been decreasing, but the evidence suggests that the performance bonus pay greatly differs still. This difference in the bonus pay component of total compensation supports the persistence of the pay gap between men and women. It may not be accidental that an increasing number of women choose to leave wage-employment and start their own business.

References

Benson, A., Li, D. and Shue, K., 2018. Do People Really Get Promoted to Their Level of Incompetence? Harvard Business Review,

Bertrand, M. and Mullainathan, S., 2001. Are CEOs rewarded for luck? The ones without principals are. The Quarterly Journal of Economics, 116(3), pp.901-932.

Green, C.P. and Heywood, J.S., 2016. Don't Forget the Gravy! Are Bonuses Just Added on Top of Salaries?. Industrial Relations: A Journal of Economy and Society, 55(3), pp.490-513.

Viland, T.M., 2008. Bonus: Changing the Distribution of Wages?: An investigation of variable wages in wholesale and retail.

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