In 2016 Dave Barnes, chief information and global business services officer of UPS, received a salary of $491,000 and a bonus payment of $251,000, while Pawan Verma, chief information and customer experience officer at Foot Locker, had a salary of $216,000 and a bonus of $664,000. Why in one case did the CIO receive the majority of his compensation in salary, while in the other case the majority of the compensation was a bonus payment? In a third case, that of Scott Laverly, the CIO of JC Penney, the salary of $473,000 was approximately equal to the bonus of $553,000. Again, what causes the mix of salary and bonus to vary across workers, even those in similar job functions? Prior economics papers concerning managerial compensation pay little attention to how and why the mix of salary and bonus varies across managers.

We develop a theory that explains how this mix is determined. Our theory embeds agency analysis into a model of promotion tournaments. In a promotion tournament model, the higher compensation associated with a promotion, i.e., the promotion prize, serves as an incentive for lower level workers to provide higher effort. Our model combines elements of two theoretical approaches. In the classic tournament approach, due initially to Lazear and Rosen, the firm commits to a promotion prize. In market-based tournament theory, the prize is due to the promotion signal, as initially put forth by Waldman. We explore — both theoretically and empirically — what this perspective implies for the use of bonus payments.

A simple way to think about bonus payments is that bonuses are higher when effort is higher. In our theory this is just part of the story. We predict that bonuses are higher when effort increases, but they are also higher when the increase in productivity associated with higher effort is higher. This follows from the agency aspect of our model. This part of our theoretical model predicts that bonus payments should increase with various factors that are associated with higher returns to effort, such as the level of a worker’s position in the job ladder, the worker’s tenure at the current job, the worker’s age, and of course the model predicts that bonuses increase with worker performance.

Because of the promotion tournament aspect of the model, promotions also serve as an incentive because promotions are associated with large compensation increases – the promotion prizes.  That is, as in standard promotion tournament models, workers provide more effort to increase the probability of promotion and thus increase the probability of receiving the higher compensation or prize associated with promotion. Further, in our model promotions and bonuses are substitutes. If promotion prizes are larger, then bonus payments are smaller because they are less needed to elicit high effort. Our theory thus also makes the prediction that bonus payments will be smaller when promotion prizes are larger.

In the second part of the paper we test our theoretical predictions employing two different datasets – the dataset explored by Baker, Gibbs, and Holmstrom in their classic 1990s papers, which consists of data from a single medium-sized US firm in the financial services industry, and a dataset that includes most of the managerial labour force in the Finnish economy. In our empirical analysis of each dataset, we find strong support for our theoretical predictions. Most interestingly, we find that increases in expected promotion prizes do indeed result in smaller bonus payments and this effect is substantial. For example, in the Finnish data we find that a dollar increase in the expected promotion prize in the following period results in an average decrease in this period’s bonus payment greater than a dollar. Our estimate of this effect in the financial services firm is smaller, but is still substantial.

Overall, our theory is based on the intuitive idea that bonuses are used to provide incentives, but that an important factor in determining the size of bonuses is that promotions are also a source of incentives.  Both theoretically and empirically, we show that bonus payments are associated with factors associated with worker productivity such as worker performance, job level, and age, which is consistent with the agency aspect of our model.  In addition, we also find that the size of promotion prizes is negatively related to bonus payments consistent with the idea that promotions and bonuses are substitute ways to incentivise workers.

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Emre Ekinci is an associate professor of management at Universidad Carlos III de Madrid. He has a PhD in economics from Cornell University. His research interests are labour economics, organisational economics, industrial organisation, and economics of innovation.

 

 

Antti Kauhanen is the research director at the Research Institute of the Finnish Economy, and a professor of economics at the University of Jyväskylä. Antti is also affiliated with the Aalto University School of Economics and the University of Oxford’s Centre for Skills, Knowledge and Organisation Performance (SKOPE). He has a PhD in economics from the Helsinki School of Economics.

 

Michael Waldman is the Charles H. Dyson professor of management at Cornell University’s Johnson Graduate School of Management. He is widely recognised as one of his field’s top researchers in the area of applied microeconomic theory, where his main fields of interest are industrial organisation, labour economics, and organisational economics. In these areas, he is best known for his work on learning and signalling in labour markets, the operation of durable goods markets, and the strategic use of tying and bundling in product markets.