Discretionary bonuses and turnover

Abstract

This paper develops a signaling model to investigate the effects of discretionary bonuses and wage increases on turnover. When the worker’s output is not contractible and the firm privately learns about the match quality between the firm and the worker, bonus payments and wage increases can convey the firm’s private information to the worker. If the firm credibly communicates favorable information about the match quality to a worker, the worker develops higher expectations concerning her career outcomes at the firm (such as future wage increases and promotions) and, consequently, becomes less likely to separate. The analysis demonstrates that although a wage increase and a bonus reflect the same information regarding the match quality, each serves a distinctly different role in terms of the worker’s turnover decision. Specifically, the firm pays bonuses to signal a good match while using wages to respond to competing offers the worker receives. The model yields testable predictions that concern how bonuses are related to wage increases and promotions and how bonuses and wage increases are related to turnover. The empirical analysis based on the data constructed from the personnel records of a large firm in the financial services industry provides support for the model’s implications.