The Effect of Compensation Caps on Risk-Taking

43 Pages Posted: 24 Aug 2018

See all articles by Niklas Kreilkamp

Niklas Kreilkamp

University of Giessen

Sascha Matanovic

University of Giessen

Friedrich Sommer

University of Bayreuth

Arnt Wöhrmann

University of Giessen

Date Written: August 14, 2018

Abstract

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

Kreilkamp, Niklas and Matanovic, Sascha and Sommer, Friedrich and Wöhrmann, Arnt, The Effect of Compensation Caps on Risk-Taking (August 14, 2018). Available at SSRN: https://ssrn.com/abstract=3230978 or http://dx.doi.org/10.2139/ssrn.3230978

Niklas Kreilkamp

University of Giessen ( email )

Managerial Accounting
Licher Str. 62
Giessen, 35394
Germany

Sascha Matanovic

University of Giessen ( email )

Managerial Accounting
Licher Str. 62
Giessen, 35394
Germany
+496419922263 (Phone)
+496419922269 (Fax)

HOME PAGE: http://www.uni-giessen.de/fbz/fb02/fb/professuren/bwl/BWL-IV

Friedrich Sommer (Contact Author)

University of Bayreuth ( email )

Universitatsstr 30
Bayreuth, D-95447
Germany

Arnt Wöhrmann

University of Giessen ( email )

Managerial Accounting
Licher Str. 62
35394, 35394
Germany

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