The Effect of Compensation Caps on Risk-Taking
43 Pages Posted: 24 Aug 2018
Date Written: August 14, 2018
Compensation systems that restrict the earnings potential of managers (caps) are widespread across the business world and have gained even more importance since the financial crisis. We employ an experiment to examine the effect of compensation caps on risk-taking. Rational choice theory predicts that caps should only restrict risk-seeking managers from taking undesired risk and should not affect the decisions of risk-averse managers. We predict and find that risk-averse managers, who—according to their risk preferences—should not be affected by the cap, also decrease their risk-taking when their compensation is capped. This effect is magnified when justification pressure is high. Before considering differences in ex-ante risk preferences, we replicate prior research and show a general risk-decreasing effect of caps. Our results have important implications for theory and practice because we show that it is important to differentiate between risk-averse and risk-seeking individuals when anticipating the consequences of compensation caps. Firms should be aware that the implementation of a capped compensation system might lead to adverse consequences, as managers—particularly risk-averse ones—might take too little risk to exploit business opportunities with a balanced opportunity/risk relationship.
Keywords: Risk-taking, risk behavior, justification, compensation caps
JEL Classification: M12, M41, M52
Suggested Citation: Suggested Citation