Aligning Incentives by Capping Bonuses

Anil Arya, Jonathan Glover and Brian Mittendorf
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Anil Arya: Ohio State University
Jonathan Glover: Carnegie Mellon University
Brian Mittendorf: Yale School of Management

Chapter Chapter 8 in Essays in Accounting Theory in Honour of Joel S. Demski, 2007, pp 169-182 from Springer

Abstract: Abstract A puzzling feature of many incentive compensation plans is the practice of capping bonuses above a certain threshold. While bonus caps are often justified on the grounds of keeping pay levels in check, it has also been argued that such caps can wreak havoc on a firm’s incentive problems. In this paper, we study a setting in which bonus caps can actually help align incentives. When a CEO is impatient, she may be tempted to take a hardline stance with a privately-informed manager in project selection: if she places little weight on future flows, she is fixated on cost-cutting and curtailing budget padding. A bonus cap can soften the CEO’s posture by inducing risk aversion and thus creating a preference for a middle ground. We show that this force can enable a judiciously chosen cap to achieve goal congruence between shareholders and a CEO.

Keywords: Bonus caps; hierarchies; incentives (search for similar items in EconPapers)
Date: 2007
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DOI: 10.1007/978-0-387-30399-4_8

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