Fairness and Luck: Contract Away or Come What May?

Abstract

In practice, managers and employees often enter into risky, uncertain contracts. Prior works shows that managers use ex post discretion to reduce the effect of uncontrollable “bad luck” on employees’ performance-based compensation, but do not use ex post discretion to reduce the effect of uncontrollable “good luck,” due to fairness concerns. We investigate whether ex ante, objective compensation plans can help address the fairness concerns that lead to this asymmetric treatment of uncontrollable events. We provide evidence that compensation plans that account for uncontrollable factors can reduce differences between individuals’ fairness perceptions in good and bad luck settings. However, controlling for uncontrollable factors does not uniformly increase perceived fairness. When a favorable state of nature is realized (good luck), individuals believe, ex post, that their compensation is less fair if their agreed-upon compensation plan limits the effect of the state of nature on their compensation than if their agreed-upon compensation plan allows the state of nature to influence their compensation. In contrast, when an unfavorable state of nature is realized (bad luck), individuals believe their compensation is more fair if their agreed-upon compensation plan limits the effect of the state of nature on their compensation. We also provide evidence for two underlying psychological processes that lead to these effects and demonstrate that the effects are not simply driven by individuals viewing higher pay as being more fair.

Keywords: contract, fairness, controllability, performance, compensation