PROMOTIONS AND BONUSES: theory and evidence from Finland and US

How do we explain why some Chief Information Officers (CIOs) receive more of their compensation in salaries while others receive theirs in bonus payments? According to a new study published in the August 2019 issue of The Economic Journal, it is because promotions and bonuses are both substitutes for incentivising workers. The research finds that where promotions are more generous, bonus payments become smaller.

The study by Emre Ekinci, Antti Kauhanen and Michael Waldman sets out to explain why the mix of salary and bonus varies among managers. For example, in 2016 Dave Barnes, CIO of UPS, received a salary of $491,000 and a bonus of $251,000. In comparison, Pawan Verma, CIO of Foot Locker, received a salary of $261,000 and a bonus of $664,000. What causes this mix of salary and bonus vary so substantially even for those in similar jobs?

Their study is based on the idea that bonuses are used to provide incentives, but that an important factor in determining the size of bonuses is that promotions are also a source of incentives. They show that bonus payments are linked to productivity, such as worker performance, job level and age. At the same time, the size of the promotion is negatively related to bonus payments, demonstrating that promotions and bonuses are both ways to incentivise workers.

The authors’ theory incorporates agency analysis into a model of “promotion tournaments”, a model developed in the 1980s that shows how the higher compensation associated with promotion incentivises lower level workers to work harder. This paper explores both theoretically and empirically what the model of promotion tournaments implies for the use and size of bonus payments.

A simple way to think of bonus payments is that bonuses are higher when effort is higher. The authors’ theory aligns with this perspective but also predicts that bonuses are higher when the increase in productivity associated with higher effort is higher. This follows from the agency aspect of the authors’ model, which predicts that bonus payments should increase with various factors that are associated with higher returns to effort such as the level of a worker’s position in the job ladder, the worker’s tenure at the current job, the worker’s age, and of course the model predicts that bonuses increase with worker performance.

In the authors’ theory where promotion prizes are larger, bonus payments are smaller because they are less needed to elicit high effort. They test this using two datasets, one from a single medium sized firm in the financial services industry in the United States and another that includes most of the managerial labour force in the Finnish economy.

Each dataset provides strong evidence for the authors’ predictions, finding that in both circumstances promotions do indeed result in smaller bonus payments – and the effect is substantial. In the Finnish data the authors find that a dollar increase in the expected promotion prize in the following period results in an average decrease in this period’s bonus payment greater than a dollar. The paper’s estimate of this effect in the financial services firm is smaller, but still substantial.

Bonuses and Promotion Tournaments: Theory and Evidence by Emre Ekinci, Antti Kauhanen and Michael Waldman is published in the August 2019 issue of The Economic Journal

Emre Ekinci

Associate Professor of Management at Universidad Carlos III de Madrid

Antti Kauhanen

Research Director at Research Institute of the Finnish Economy

Michael Waldman

Charles H. Dyson Professor of Management and Professor of Economics at Cornell SC Johnson College of Business