The Effect of Bonus Scheme and Bonus Deferral on Risk Propensity: An Experimental Analyis

The financial crisis has enhanced the attention in practice and academia of the effects that pay-for-performance systems may have on the risk inclination of decision makers in financial institutions. Regulators have developed several remuneration codes of conduct for designing pay-for-performance systems to mitigate managerial risk propensity in financial institutions. This paper addresses two prominent recommendations in these codes - the effects of a negative bonus and bonus deferral on managerial risk propensity. In a two period experiment we investigate the effects of compensation alternatives on subjects’ willingness to invest amounts of money in a risky project. In the first period, we find higher risk propensity under the non-capped bonus scheme that contains a potential of a negative bonus. While bonus deferral appeared to have no initial effect on risk propensity, it strengthened risk avoidance and risk seeking tendencies associated with negative and positive outcomes of financial decision from the first period investments. This finding corresponds to the phenomenon previously reported in the literature as ‘the house money’ effect (Johnson & Thaler, 1990, Barberis and Huang, 2001). All in all, deferred payment may not unconditionally decrease risk taking, as it is hoped for by the regulators. The compensation design that does not deal with this effect is very likely to contain a risk of pro-cyclicality that may in good times induce excessive risk taking and in bad time excessive risk aversion. The findings contribute to the theory and practice of bonus system design and the application of contemporary remuneration codes.