Bonuses can often be depicted as additional and excessive compensation payments, particularly for senior management; however, a UK study investigated if bonuses generally act as a substitute for fixed compensation or as an addition to it. The study findings suggest that bonuses are typically a partial substitution of fixed compensation, with the extent of substitution being much larger in lower paid jobs.
Key Topics: Bonus; Variable pay; Pay for performance
Title of Reviewed Article: Don’t Forget the Gravy! Are Bonuses Just Added on Top of Salaries?
Researchers: Colin P. Green (Lancaster University) and John S. Heywood (University of Wisconsin–Milwaukee).
Publication: Industrial Relations, 2016, Vol. 55 No. 3, pp. 490-513.
Setting the Scene
Often in the media, bonuses are reported in a negative light, and with the suggestion often being that bonuses are something for nothing. This perception in the media, and by the wider public, is somewhat inconsistent with the fundamental theory of bonuses being a mechanism through which companies drive performance of individuals and the company as a whole, with payments often contingent on performance metrics. Advocates of bonuses argue that they are instead of fixed compensation, rather than in addition to it, and that reducing or capping bonuses would lead to an increase in fixed compensation. Also, the idea that performance related pay elicits increased performance is a well-established concept (Lazear, 2000; Shearer, 2004).
There is relatively limited research on the bonus substitution effect (e.g. Barkume, 2004) and as such the current study looks to review this effect in greater detail. This study also looks to add to previous research which found that bonuses are increasingly prevalent among higher earners (e.g. Bell & Van Reenen, 2013). The researchers focus, not on an examination of inequitable distribution of bonuses, but on the extent that bonuses are an element in a reward structure in which variable compensation is present because fixed compensation is lower.
How the research was conducted
This study examined 1997 to 2008 data from the British Household Panel Survey (BHPS). This survey interviewed approximately 10,000 individuals annually and collected information on earnings, including variable pay components. The researchers limited their analysis to males working in the private sector.
Based on this information, the researchers developed a number of estimates to determine the extent of bonus substitution. In their model, complete bonus substitution infers that an additional pound (£) of bonus will not increase annual earnings. While on the other end of the scale, no substitution would see annual earnings increase by at least the value of the bonus.
Key Research Findings
The analysis of results found that bonuses were partial substitutes for other fixed earnings. Specifically, the study found that, on average, for every pound (£) of bonus this translated into approximately 60p of increased earnings. Additionally, the researchers found that the extent of substitution was much greater at the lower end of the earnings distribution. As a proportion of annual earnings, bonuses were found to be much greater at the higher earnings levels, with the proportion increasing significantly for the top 5% or earners, and therefore serving more of a complementary function to fixed pay at these higher levels.
Additionally, the researchers found that those receiving bonuses were more likely to receive other performance related pay and their annual earnings were typically higher than those not receiving bonuses.
Interestingly, the researchers found that, over the period from 1997 to 2008, bonuses increased significantly, reaching a high in 2007, but there is then a notable decrease in 2008, coinciding with the global financial crisis.
The limited prior research which found substitution between variable and fixed compensation was one of the starting points of the current research, and given that the success of bonus payments from a company perspective is dependent somewhat on the level of substitution, this is an important point.
Unsurprisingly, the researchers found a positive relationship between bonuses and total compensation, with the presence of bonuses generally coupled with higher total compensation. This relationship indicated a partial substitution effect rather than a complementary one. So, while generally much less than the full value of bonuses is observed in total compensation, there is an additional increased cost associated with bonuses.
The researchers found a large degree of difference across the total earnings distribution. Interestingly, at the lower earnings levels there was a very high substitution of bonus for fixed pay, but this dissipated significantly as earnings increased, to the point of having very low substitution at the top of the earnings distribution scale. The researchers speculated that the bonuses at the top of the earnings distribution could be significantly different to those at the bottom, although it does appear from the findings that bonuses at these levels serve more as a ‘top up’ rather than a substitution of fixed compensation, and does provide some fuel to the notion that bonuses for high earners are excessive, although this would likely be a simplistic view given that the higher bonuses may be performance driven.
Organizational and Reward Implications
The findings of this study are certainly interesting and from a practical perspective this research highlights the need for companies to consider the distribution of bonuses within their organization. While the mix of compensation given for a particular job is often driven by market forces it is nonetheless important for companies to determine if they are getting most value from their compensation mix policy and to what extent variable compensation is adequately tied to performance in order to yield most value.
This research does suggest that there is some justification in public perception of bonuses being a top up on salaries at senior management levels. It is also particularly striking that the partial substitution found between fixed pay and bonuses reduces significantly as earnings increase. What is less clear from the research however is whether the bonuses are indeed ‘something for nothing’. Further research is needed on the mechanisms behind bonuses plans and to what extent the finding that bonuses only partially substitute bonuses are a result of individuals driving company performance, surpassing performance targets and receiving higher bonuses as a result, it could well be that higher bonus costs are related to greater performance.
Source Article: Green, C. P., & Heywood, J. S. (2016). Don’t Forget the Gravy! Are Bonuses Just Added on Top of Salaries? Industrial Relations, 55(3), 490-513.
Published by: Wiley Periodicals, Inc.
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Barkume, A. J. (2004). Using Incentive Pay and Providing Pay Supplements in U.S. Job Markets. Industrial Relations, 43(3), 618–633.
Bell, B. D., & Van Reenen, J. (2013). Extreme Wage Inequality: Pay at the Very Top. American Economic Review, 103(3), 153–157.
Lazear, E. P. (2000). Performance Pay and Productivity. American Economic Review, 90(5), 1346–1361.
Shearer, B. (2004). Piece Rates, Fixed Wages and Incentives: Evidence from a Field Experiment. The Review of Economic Studies, 71(2), 513–534.