Bonus Pools Research Articles

Dynamic Bonus Pools

ABSTRACT We study the properties of long-term bonus pools (BPs) with rollover provision in a multiperiod moral hazard setting, where the principal uses subjective information to privately assess the agent’s performance and the agent is protected by limited liability (LL). To provide incentives, the principal funds a multiperiod BP with a fixed payment that may be distributed over time to the agent and a third party. We find that the optimal long-term BP contract features performance targets that are contingent on past performance. Specifically, high subjective performance implies an easy target, and low subjective performance implies a difficult target. To implement the long-term BP contract, the principal provides nondichotomous performance reports. The study contributes to the literature that discusses the mechanisms that make subjective performance information useful for incentive contracting. JEL Classifications: D82; M52; M54.

Team Incentives and Bonus Floors in Relational Contracts

A common means of incorporating non-verifiable performance measures in compensation contracts is via bonus pools. We study a principal-multi-agent relational contracting model in which the optimal contract resembles a bonus pool. It specifies a minimum joint bonus floor the principal is required to pay out to the agents and gives the principal discretion to use non-verifiable performance measures to both increase the size of the pool and to allocate the pool to the agents. The joint bonus floor is useful because of its role in motivating the agents to mutually monitor each other (team incentives). In an extension section, we introduce a verifiable team performance measure, in part to establish the robustness of our results. In this case, the optimal contract either ignores the team measure completely or uses it to create a conditional bonus floor (a floor only when the team measure is high). There is a minimum precision requirement on the team measure that has to be satisfied before the team measure is used to motivate mutual monitoring.

Discretionary Bonus Pools and Employeess Influence Activities: An Experimental Investigation

This study experimentally investigates how the extent of superior discretion over the allocation of a bonus pool affects the output of a team when employees can engage in unproductive influence activities. Granting superiors high discretion allows them to use non-verifiable information and observations in order to mitigate free-rider incentives in teams. Prior research, however, also suggests that discretion may give rise to unproductive influence activities of employees. The question, therefore, is whether organizations should reduce superiors’ discretion extent in order to mitigate influence activities in teams. Conventional economic theory assumes that superiors optimally account for influence activities in bonus decisions if they have incentives to do so. Reducing the discretion extent therefore harms superiors’ flexibility and may impair the efficiency of discretionary bonus pools. Relying on behavioral theory, however, I argue that superiors likely overweight their personal information in bonus decisions. This increases incentives for employees to engage in influence activities under high discretion and detracts them from contributing to team output. I thus predict that reducing superiors’ discretion extent actually increases team output. Furthermore, I predict and show that the degree of mutual monitoring between peers amplifies the positive effect of reducing superiors’ discretion extent. The reason is that influence activities of peers are more salient under a high degree of monitoring and thereby affect behavior and fairness perceptions of employees more strongly. Reducing the discretion extent therefore becomes particularly important with higher degrees of mutual monitoring. This study contributes to the literature on discretionary bonus pools by providing evidence on the failure of superiors to sufficiently account for influence activities in bonus decisions and, thus, on the benefits of limiting superiors’ discretion extent.

Are Bonus Pools Driven by Their Incentive Effects? Evidence from Fluctuations in Gainsharing Incentives

Bonus pools, in which a worker’s realized bonus depends both on a worker’s share of the pool (which serves as the incentive) and on the size of the pool (which is largely outside of the worker’s control), are a common method for distributing incentive pay. Using data on the variation in the size of the bonus pool generated by a US manufacturing plant’s gainsharing plan, which varies incentives for quality and worker engagement, the authors evaluate the conditions under which such bonuses have incentive effects. Overall, results are cautionary: The evidence suggests gainsharing’s benefits operate outside of the incentive channel, and incentives may backfire if they are too small or too diluted by group performance metrics. The authors illustrate how random variation in the size of bonus pools offers researchers a powerful, readily available, and underused tool for studying how workers respond to the availability and strength of incentives.

Are Bonus Pools Driven by their Incentive Effects? Evidence from Fluctuations in Gainsharing Incentives

Shared bonus pools, in which a worker’s bonus depends both on a worker’s share of the pool (which serves as the incentive) and also on the size of the pool (which is largely outside of the worker’s control), are a common method for distributing bonus pay. Using variation in the size of the bonus pool generated by a manufacturing plant's gainsharing plan, which varies incentives for quality and worker engagement, we evaluate the conditions under which incentives distributed from bonus pools actually have incentive effects. Overall, results are cautionary: the evidence suggests gainsharing's benefits operate primarily through simultaneously-adopted process improvement practices rather than gainsharing's incentive effects, and incentives can backfire if they are too small or use plant-level performance metrics. We note that random variation in the size of bonus pools offers researchers a powerful, readily available, and underused tool for studying how workers respond to the strength of incentives.

Bankerss Compensation: Sprint Swimming in Short Bonus Pools?

Regulators restrict bankers' risk-taking incentives by using a bonus cap or by extending the effective bonus accrual period. We build a structural model to assess the effect of these bonus restrictions. The calibrated model suggests that extended bonus accrual periods alone do not lead to lower risk-taking while a suffi ciently tight bonus cap does. A bonus cap that equals fixed salary (as in the EU) reduces risk on average by 13%.

First, do no harm Capital Failure: Rebuilding Trust in Financial Services Nicholas Morris and David Vines, Eds. Oxford University Press, 2014. 422 pp.

First, do no harm <b>Capital Failure: Rebuilding Trust in Financial Services</b> <i>Nicholas Morris and David Vines, Eds.</i> Oxford University Press, 2014. 422 pp.

FOREWORDSome Ideas for Further Research in Managerial Accounting

S tanley Baiman, William H. Lawrence Emeritus Professor at the Wharton School, University of Pennsylvania, and Adjunct Professor at Bocconi University in Milan, Italy, is among the most influential contributors to the field of management accounting. Whereas his work and its reach have been both deep and broad, there are three strands in his work over the last 30 years across his circa 30 articles in major journals. In the 1980s, Professor Baiman was pivotal in jump starting the literature on agency problems in accounting, with Joel Demski, the 2011 winner of this Lifetime Contribution Award. Stan was a pioneer with agency theory in accounting, which became an important research framework in management accounting since its ‘‘invention’’ in the late 1970s. Stan’s early work led us to rethink how classic managerial accounting ideas, like variance investigation and responsibility accounting, are impacted when used to measure and evaluate managerial performance. In the mid-1990s, Stan and his coauthors made important progress on organizational design and multi-agent contracting problems. The interplay of contracting and organizational design is at the heart of management accounting. Particularly of note here is the paper ‘‘On the Usefulness of Discretionary Bonus Schemes’’ (The Accounting Review 1994), where the ingenious solution of a ‘‘budget balancer’’ was introduced in the setting of a bonus pool with multiple agents. This paper triggered significant follow-up work to the present and has been key in explaining the ubiquity of bonus pools in practice. In the early 2000s, Stan’s research focus shifted to examining management accounting issues in inter-firm contracting problems, such as in supply chains. Much of this work adopts an ‘‘incomplete-contracting’’ logic where contracts are too complex and too dynamic to be completely specified in advance. His survey article in this area, ‘‘Incentive Issues in Inter-Firm Relationships’’ (Accounting, Organizations and Society 2002), describes this in sufficient detail to help new researchers in the area, but is intuitive enough to be readable by consumers, and not just the producers, of this style of research. Professor Baiman has written a number of influential surveys, which have become essential reading for Ph.D. students and researchers throughout the world in accounting, as well as adjacent fields. His survey articles ‘‘Agency Research in Managerial Accounting’’ (Journal of Accounting Literature 1982) and ‘‘Agency Research in Managerial Accounting: A Second Look’’ (Accounting, Organizations and Society 1990) were not only invaluable to agency researchers, but also made the field accessible to nonagency (and nonanalytical) researchers.

Bonus pools and the informativeness principle

Previous work on moral-hazard problems has shown that, under certain conditions, bonus contracts create optimal individual incentives for risk-neutral workers. In our paper we demonstrate that, if a firm employs at least two workers, it may further benefit from combining worker compensation via a bonus-pool contract and relative performance evaluation. Such combination leads to saved rents under a wide class of luck distributions. In addition, if the employer is wealth-constrained, complementing individual bonus contracts by the possibility of pooling bonuses can increase the set of implementable effort levels. All our results hold even though workers' outputs are technically and stochastically independent so that, in view of Holmstrom's informativeness principle, individual bonus contracts would be expected to dominate bonus-pool contracts.

Bankers' Compensation: Sprint Swimming in Short Bonus Pools?

The global financial crisis of 2007-2008 has given rise to new regulatory initiatives to put restrictions on the size and term of bankers' pay. We revisit the question whether these regulations are justified, both theoretically and empirically. We model bonuses as a series of sequential call options on profits and show that they provide the higher risk-taking incentives the shorter is the time between the payment points. However, using data on CEO bonuses at the end of 2006 and our model, we find no robust relationship between risk-taking incentives and US banks' stock returns during the global financial crisis. The crisis returns are related negatively to leverage and positively to the market to book equity ratio. Our findings suggest that regulating leverage would be more effective than regulating bankers' compensation. Keywords: Banking, bonuses, regulation, compensation

BOOK REVIEWS

BOOK REVIEWS

Dividing the Pie: The Influence of Managerial Discretion Extent on Bonus Pool Allocation*

An essential role of management is organizational control, or the process of ‘‘ensuring that the organization operates in the intended manner and achieves its goals’’ (Hilton 2008: 6). Accountants support managers in this role by providing information that forms the basis of performance evaluation and incentive-based contracting. However, managers also have available to them other relevant employee performance information — that is, information not explicitly contracted on because it represents unforeseen circumstances, cannot be jointly verified or requires interpretation or judgment. To incorporate this noncontractible information into compensation decisions, firms often allow managers discretion in determining subordinates’ compensation. Specifically, many firms use discretionary bonus pools as the mechanism via which managers apply discretion in compensation. Whereas the size of a bonus pool (in dollars) is typically based on some predetermined formula, firms vary greatly in the extent to which managers are endowed discretion to allocate that pool (Murphy and Oyer 2003). That is, some plans allow managers full discretion in allocating the bonus pool, whereas other plans allow discretion over only a portion of the total pool, with the remainder contractually allocated by formula. In this paper, we investigate the effect of this important institutional factor — discretion extent — on managers’ discretionary bonus allocations. To examine the effect of discretion extent, we develop theory on the processes by which managers will allocate discretionary bonus pools. Analytic research (e.g., Rajan and Reichelstein 2006) models each bonus pool participant’s allocation as a linear combination of performance measures. This linear combination may be conceptualized as a single, comprehensive measure of performance, in which all relevant (contractible and noncontractible) information is integrated. Based on this conceptualization, one might assume that in

Tax Arbitrage Feedback Theory

A new angle for understanding the global credit crisis of 2008-2009 is presented. Based on control theory principles and the axiom that investors seek the highest, expected after-tax return, I develop the Tax Arbitrage Feedback Theory. TAFT explains how the subtle effects of differential tax rates for various market participants produce incentives that strongly contribute to instability and boom/bust economic activity. Moreover, TAFT explains how observed bond credit spreads should be impacted by differential tax rates, in addition to the conventional bankruptcy and recovery factors. The purpose of debt securitization products, when viewed through a TAFT lens, is not only diversification and partitioning of risk, but also tax minimization. Credit default swaps are revealed to be a massive tax arbitrage that shifted government tax receipts to Wall Street bonus pools and necessitated the creation of massive quantities of low credit quality debt.

Incentive Effects in Tournaments with Heterogeneous Competitors – an Analysis of the Olympic Rowing Regatta in Sydney 2000

A large part of the theoretical tournament literature argues that rank-order tournaments only unfold their incentive effects if the contestants all have similar prospects of winning. In heterogeneous fields, the outcome of the tournament is relatively clear and the contestants reduce their effort. However, empirical evidence for this so-called contamination hypothesis is sparse. An analysis of 442 showings at the Olympic Rowing Regatta in Sydney 2000 gives evidence that oarsmen spare effort in heterogeneous heats. This implies that competition among staffs with heterogeneous skill levels does not bring about the intended effort levels. However, a separate subgroup analysis shows that only the tournament favourites hold back effort whereas underdogs bring out their best when competing against dominant rivals. A heterogeneous tournament could then be enriched by absolute performance standards to increase incentives of the favourites. Key words: tournaments, heterogeneity, incentive effects, effort 1. Introduction As has been shown by Lazear/Rosen (1981), rank-order tournaments work, under certain conditions, as optimal labour contracts yielding the first best level of effort in an environment characterised by moral hazard. Hence, tournaments are not only of academic interest, but quite prominent in day-to-day work environments. For example, co-workers compete for promotions in internal labour markets (Malcomson 1984; Rosen 1986; Lazear 1989; Baker et al. 1994), teams compete for a project, firms compete for contracts. Furthermore, firms set bonus pools that are divided among staffs according to their relative performance (Krakel 2002; Raj an/Reichelstein 2006), e.g. in sales forces. Formally, such competition for bonuses also can be modelled as a tournament. Tournament literature suggests that competition will only have incentive effects if an increase in effort increases the chances of winning. In heterogeneous fields, the underdog quickly realises his minimal chances of winning and reduces his effort to the level that just about secures the achievable rank. Vice versa, the favourite anticipates a noticeable competitive edge early on in the tournament. This implies two strategies. First, he also holds back effort right from the start. Second, he reduces his effort as soon as he realises the slowdown of his inferior competitors. The favourite will only increase his effort if he can expect to thereby increase his chances of winning. In this line of argument, heterogeneous tournaments do not have incentive effects; other incentive systems are more likely to affect employees (Frick et al. 2008: 385ff.). As a general conclusion, the incentive to put in additional effort decreases with increasing heterogeneity among competitors. Despite its prominent role in the theoretical tournament literature, nonexperimental empirical evidence for the so-called contamination hypothesis is only limited. In their analysis of PGA-golf tournaments Ehrenberg/Bognanno (1990) did not find unambiguous negative impact of competitor heterogeneity on incentive effects. Independent from their own score, a match partner with a higher player score (exempt players) leads to an underperformance of golf players. For below-average players (nonexempt players), this is in line with the literature. On the other hand, above-average players should be challenged and motivated by the additional competition. However, this could not be confirmed in the study by Ehrenberg/Bognanno (1990). Horse race studies as e.g. provided by Lynch (2005) confirm that a closer competition motivates contestants to higher effort levels. Riders put in more effort in the second half of a race if the margin to the next best rank is only small; i.e. the rider hopes to win a rank by increasing his effort. Finally, with the help of data from the German soccer league, Frick et al. (2008) show that in narrow matches players are more often sanctioned with yellow and yellow/red cards. …

Dividing the Pie: Do Managers Fully Incorporate Non-Contracted Information into Full and Partial Discretionary Bonus Allocations?

Research indicates that bonus plans can provide effective incentives when managers use discretion to incorporate non-contracted information into performance evaluations. The use of managerial discretion, however, draws concern about whether non-contracted information is used appropriately in performance evaluations (Baiman and Rajan 1995; Fisher et al. 2005). This paper provides experimental evidence regarding the decision processes through which managers apply discretion in allocating bonus pools. Additionally, we investigate whether the design of the bonus plan affects managers' bonus allocations. Our theory and evidence suggest that managers rely on an anchoring and adjustment heuristic to allocate bonus pools and that the bonus plan type (i.e., whether managers have full or partial discretion) influences managers' choice of anchor information. Regardless of anchor information, managers' subsequent adjustment is insufficient, resulting in a failure to fully incorporate non-contracted information. Even for those managers who do not rely on an anchoring and adjustment heuristic but instead attempt to perform comprehensive calculations, only those with full discretion fully incorporate non-contracted information.

Subjective Performance Indicators and Discretionary Bonus Pools

Key indicators of managerial performance are frequently subjective, that is, they are difficult to specify and/or verify for contracting purposes. When a principal must rely on subjective information to create incentives for a group of agents, discretionary bonus pools are shown to be optimal mechanisms. Despite their optimality, however, discretionary bonus pools entail an additional agency cost relative to the benchmark of optimal contracts based on objective and verifiable information. Our analysis identifies circumstances under which this additional agency cost is small, for example, the subjective information signals are precise, or the number of agents participating in the bonus pool increases. When incentive schemes can be based on both objective and subjective performance indicators, the relative weights to be placed on alternative signals are shown to differ from the ones predicted by models with objective signals only. We also demonstrate that correlation in measurement errors has a different impact on the structure of optimal incentive schemes when the performance indicators are merely subjective.