Don't Forget the Gravy! Are Bonuses Just Added on Top of Salaries?

Abstract

The press often depicts bonuses as extra payments to the already well compensated and calls for reform. Yet, these calls typically ignore the efficiency argument that bonuses are potentially risky performance pay that substitute for salary compensation. This paper uses representative UK data to estimate that bonuses appear not to substitute for salary in cross-sectional estimates. Yet, when controlling for time-invariant characteristics in panel data, bonuses emerge as partial substitutes. Each pound of bonus comes at a cost of 40 pence in other earnings. The degree of substitution is far larger at the bottom of the earnings distribution and far smaller at the top of the earnings distribution where, indeed, bonuses look more like gravy. IntroductionThe payment of bonuses as part of managerial and executive compensation attracts continued public controversy. The media highlight the size of bonuses paid at financial institutions, often with the application of pejorative terms such as "bonus culture" that suggest the payment of something for nothing. 1 Indeed, the depth of public feeling regarding bonuses has led to pronouncements by both the U.S. president and the UK prime minister on the need to restrain these "inequitable payments" and proposed legislation to cap bank bonuses in the EU. The public perception of something for nothing seems at odds with the basic theory that bonuses, like other forms of performance pay, represent a *The authors' affiliations are, respectively, Lancaster University, Lancaster, United Kingdom. 490 means to mitigate agency problems in labor contracts. Payment contingent on worker performance stands in lieu of some portion of an otherwise riskless (or at least less risky) salary payment and serves to increase firm profitability, worker utility, or both. In fact, the presumption that high performance bonuses substitute for salaries provides the basis for the resistance by both the UK and U.S. financial sector to cap or reduce bonus payments. Advocates for the sector explicitly claim that reducing bonuses will lead to either a necessary compensating increase in salary payments or a loss of talent within the sector.The basic notion that performance pay elicits additional effort and is associated with increased earnings stands as well engrained in the economics of personnel (Brown 1992;Lazear 2000;Parent 1999;Shearer 2004). Yet, the combination of the disutility from greater effort and risk has left in doubt the extent to which the higher pay generates higher worker utility from performance pay (Cornelissen, Heywood, and Jirjahn 2011; Green and Heywood 2008). At least part of the answer of whether or not workers benefit from performance pay revolves around the critical issue at the heart of the public debate, the extent to which performance pay substitutes for fixed-time rates. As we will detail, previous empirical results often fail to find any substitution showing that higher performance payments tend to be associated with higher fixed-time rates. If correct, the performance pay in these...

The Rise in Pay for Performance Among Higher Managerial and Professional Occupations in Britain: Eroding or Enhancing the Service Relationship?

“…While the estimation of (1) and (3) are relatively straightforward, which involves interacting a PFP dummy variable with occupational class categories then calculating the differences between PFP and non-PFP jobs within classes using the first derivatives (in the case of ordinary least squares (OLS) regression models) or average partial effects (in the case of the logistic regression models), (2) requires a little more elaboration. We follow the approach of Green and Heywood (2017) who use the amount of annual PFP (in £) as a key independent variable, and overall annual earnings as the dependent variable (in £). We interact PFP amount with occupational class and obtain the derivatives of PFP on earnings within classes for this analysis.…”

“…While empirical research often finds a pay premium for PFP, this does not signify a strengthening per se since much of the premium is often also found to reflect a large degree of unobserved heterogeneity. The PFP pay premium substantially shrinks in panel studies that control for individual fixed-effects (e.g., Bryan and Bryson 2016;Bryson et al 2014;Green and Heywood 2017;Stokes et al 2017). Moreover, Green and Heywood (2017) in the British Household Panel Survey 1997 to 2008 show that PFP often substantially substitutes for base earnings such that simplistic estimates of the PFP pay premium may therefore overstate the financial benefit of PFP, even when taking unobserved heterogeneity into account.…”

“…Although insightful that the pay premium is larger for higher managerial and professional occupations relative to other classes, what is of primary interest to the research questions posed earlier is the extent to which PFP pay complements or substitutes base pay and how this varies across classes. As previously mentioned, to explore this we follow the approach of Green and Heywood (2017) by examining the effect size of PFP amount (in £s) on overall earnings, which gives the effect of a £1 increase in PFP on total annual earnings. An effect greater than 1 implies that PFP is acting as a complement to base earnings while an effect less than 1 indicates that as PFP increases, overall pay increases less than the value of PFP, implying base earnings are being substituted by PFP.…”

“…Bryan and Bryson, 2016; Bryson et al, 2014; Green and Heywood, 2017; Stokes et al, 2017). Moreover, Green and Heywood (2017) in the British Household Panel Survey 1997 to 2008 show that PFP often substantially substitutes for base earnings such that simplistic estimates of the PFP pay premium may therefore overstate the financial benefit of PFP, even when taking unobserved heterogeneity into account.…”

Performance pay and assortative matching

“…The BHPS allows us to observe couples, performance pay and earnings for all adult household members. It provides measures for receiving individual performance pay (IPP) and for bonuses (see Green and Heywood, 2016).…”