Bonus Rigidity and Future Performance: Theory and Evidence

Abstract

Drawing on the extensive economics literature on wage rigidity, we examine CEO bonus rigidity and, in particular, the implications of downward bonus rigidity for future performance. We first document distributional support for downward rigidity in bonus payments. More importantly, we find that bonus cuts have distinct negative implications for future firm performance. Indeed, our evidence indicates that bonus rigidity is the primary driver of the positive relation between unexpected cash compensation and future performance documented by Hayes and Schaefer (2000). Our evidence is also broadly consistent with morale theories of pay rigidity (Bewley, 1995, 2002; Yellen, 1984) which posit that employers avoid reducing nominal wages due to the adverse impact that such cuts have on employee morale. This relation in turn suggests that morale consequences are an important factor in management compensation committee decisions to shield pay from adverse performance outcomes such as losses (Dechow et al., 1994; Gaver and Gaver, 1998).

Keywords: Bonus Compensation, Performance Prediction, Compensation Shielding, Pay Rigidity

JEL Classification: E24, J3, M49