Compensation Discretion as Insurance:
How are Targets and Bonuses Affected When Superiors Have a Back-up Plan?
Rachel Martin
Utah State University
Tyler Thomas
University of Wisconsin-Madison
September 27, 2017
We would like to thank faculty and students at the University of Wisconsin-Madison for their helpful comments and suggestions on the experimental design. We are grateful for the comments offered by Wendy Bailey, Matthew Critchley, Devon Erickson, Michael Majerczyk, Ella Mae Matsumura, Kari Olsen, Michael Paz, Kyle Stubbs, Todd Thornock, workshop participants at Iowa State University and the University of Wisconsin-Madison, and participants at the BYU Accounting Research Symposium,the Managerial Accounting Experimental Brown Bag, the Management Accounting Section Midyear Meeting, and the AAA Annual Meeting. We are thankful for the funding provided by the Institute of Management Accountants, the Behavioral Research Insights Through Experiments Lab at the University of Wisconsin-Madison and the Department of Accounting and Information Systems of the Wisconsin School of Business.
Compensation Discretion as Insurance:
How are Targets and Bonuses Affected When
Superiors Have a Back-up Plan?
Abstract
Target setting by superiors and their discretion in compensation decisions are important pieces in an organization’s control system.Thus, we examine how these processes affect each other and superiors’ decisions therein. We predict, and experimentally find, that superiors with ex post compensation discretion set more aggressive targets and put less time into the target-setting process, as they rely on their discretion as insurance against setting an overly aggressive target with insufficient effort. This is an important finding, as past research shows that subordinates find aggressive targets especially demotivating when their superiors have ex post discretion. Further, superiors with ex post discretion focus more on the ex post bonus outcome rather than the ex ante target and are more likely to adjust for bothpositive and negative uncontrollable effects on subordinate compensation. Lastly, we further examine the target-setting process by analyzing the effect of Dark Triad personality traits on superiors’ target-setting decisions. We find thathigh Dark Triad superiors with ex post discretion set the most aggressive targets, but without ex post discretion these superiors set the least aggressive targets.This facet can be considered in the design of compensation plans and provides insight as to why compensation plans affect individuals differently.
Keywords: target setting; compensation discretion; bonus adjustments; Dark Triad
1
- Introduction
Subordinate motivation is crucial for organizational success, and superiors use targets and incentives, in part, to influence the effort subordinates are willing to exert. The target setting process and superiors’ ability to make adjustments to subordinates’ compensation at the end of the period (ex post compensation discretion) are both critical factors in a firm’s control system. There is a paucity of research, however, evaluating how these two processes—target-setting and ex post compensation adjustments—together influence superiors’decisions. It is crucial to understand how superiors navigate these two processes (target-setting and ex post compensation adjustments), as these decisions can directly influence subordinate behavior.
Difficult targets can motivate individuals(e.g., Locke and Latham 1990), but subordinate motivation suffers when superiors set aggressive targets and subordinates know that superiors have ex-post discretion to change their compensation (Burt, Libby, and Presslee 2015; Kelly, Webb, and Vance 2015). If superiors believe that ex post discretion gives them the flexibility to set more aggressive targets because compensation can be adjusted at the end of the period, then the findings of past research suggests that subordinate motivation will suffer.We thus seek to evaluate how superiors’ awareness of ex post compensation discretion affects the targets they set for their subordinates, and in turn, how being involved in the target setting process affects how superiors make bonus adjustments ex post.
In the evaluation and compensation process,superiors can draw upon both past experience and expectations of future experience to inform current decisions, including the effects of their decisions onsubordinate motivation and retention, their reputation as a skilled leader, damage to personal relationships, and confrontation costs with the affected subordinates(Harris 1994; Bol 2011; Woods 2012). Thus, as superiors determine targets for their subordinates ex ante,their decisions can be affected by perceptions of future effects and consequences. Hence, we argue that having discretion to adjust subordinate compensation at the end of the performance period will affect the targets that superiors set at the beginning of the period.
Difficult but attainable targets can motivate individuals and lead to high performance(Locke and Latham 1990; Locke and Latham 2002), which can drivesuperiors to set aggressive targets for their subordinates to motivate them to achieve high performance. Further, setting a high target can provide some information to the superior as to the subordinate’s ability level, dependent on whether the aggressive target can be attained or not. Aggressive targets, however, can impose risk on subordinates and potentially increase confrontation costs, which can reduce superiors’ tendencies to increase target aggressivenesswithout other mechanisms to limitthis risk(Moers 2005). Organizations can reduce subordinates’ compensation risk by providing superiors with ex post compensation discretion,which can improve incentive alignment(Gibbs, Merchant, Van der Stede, and Vargus 2004; Gibbs,Merchant, Van der Stede, and Vargus2005), but we argue that superiors will use the flexibility provided by ex post discretion to set more aggressive targets ex ante in an effort to increasesubordinatemotivation, knowing that any unintended compensation risk from an overly aggressive target can be adjusted ex post. Thus, we predict and find that superiors who have ex post compensation discretion set more aggressive targets than superiors who do not have ex post discretion.
We further posit that superiors can rely on ex post compensation discretion to decrease their ex ante target-setting effort.[1] Ex post discretion allows superiors to correct for any new information that comes to light after setting the target, which reduces the incentive to exert effort to uncover information in the target-setting process. Further, following intertemporal discounting, individuals tend to devalue future costs compared to current costs(Soman et al. 2005). Thus, the cost of currently exerting effort in setting targets is more salient to superiors than that of making future discretionary adjustments, leading superiors to prefer the possible need to expend effort in the future to make discretionary adjustments over fully exerting effort in the present to set an appropriate target. Hence, we predict and find that superiors exert less effort setting targets when they have ex post compensation discretion than when they do not.
Target setting can also influence bonus adjustments. When superiors set targets, their focus ex ante is mainly on motivating subordinates to meet the firm’s objectives, but their focus at the end of the period is to be fair in evaluating the subordinate, generally focusing on positive over negative adjustments(Bol and Smith 2011; Deason, Hecht, Tayler, and Towry 2014). As superiors with ex post compensation discretion set aggressive targets, but exert less effort in this process, they will feel more responsible for the subordinate’s performance to target. Thus, these superiors will focus more on the bonus outcome and their ability to make adjustments for incomplete targets, leading to a greater desire to make ex post correcting adjustments. Superiors who do not have ex post discretion exert more effort to set an appropriate target and are more likely to feel that they performed their due diligence ex ante, resulting in less of a desire to be able to make adjustments ex post. Thus, we hypothesize and findthat superiors with ex post discretion are more likely to make ex post bonus adjustments, both positive and negative, than superiors without discretion would if they had the opportunity.
Lastly, we evaluate the effect of Dark Triad personality traits (i.e., Machiavellianism, narcissism, and psychopathy) on how superiors negotiate the target-setting process with or without ex post compensation discretion. This is of interest for several reasons. First, the Dark Triad personality traits are linked to aggressive, short term, and risk-seeking behavior, which can affect superiors’ aggressiveness in the target-setting process, and can significantly affect company strategy, accounting policies, and accounting related decisions (e.g., Chatterjee and Hambrick 2007; Olsen, Dworkis, and Young 2014; Majors 2016). Second, individuals who ascend to higher positions within a company tend to be those with higher levels of the Dark Triad personality traits(Judge, Piccolo, and Kosalka 2009; Babiak, Neumann, and Hare 2010; Wille, De Fruyt, and De Clercq 2013). Understanding how these individuals respond to compensation discretion can give insight into the advantages and disadvantages of compensation discretion at different levels in the hierarchy. Lastly, generations currently entering the work force have higher levels of Dark Triad personality traits, especially narcissism, than previous generations. This difference has implications for how these individuals prefer to be managed and the type of managers they will become(see Young, Du, Dworkis, and Olsen 2015 for a review of the rise in narcissism and its implications). Gaining insight intohow Dark Triad personality traits affect superiors’ approach to target-setting with or without ex post discretion will shed light on the ways these important facets of the managerial control system will change as these new generations enter the work force.
As the Dark Triad personality traits are linked to aggressive, short term, and risk-seeking behavior, we expect superiors with high levels of these traits to set more aggressive targets and exert less effort to set these targets than those superiors with low levels, as theywill focus more on setting aggressive targets to push subordinates and less so on what the ‘appropriate’ target should be.High Dark Triad superiors, however, respond more strongly to constraints, becoming hyper-rational and adapting their responses to maintain positive impressions (Judge et al. 2009;Young et al. 2015; Majors 2016). The target-setting process is more constrained for superiors who do not have ex post discretion, as adjustments cannot be made in the future. Hence, under this constraint, these superiors will be more likely to rationally weigh the costs and benefits of target aggressiveness and subordinates’ perceptions of them as a target setter. Thus, we predict that the Dark Triad personality traits will moderate the effect of ex post discretion on target levels and the effort exerted in the process, with a greater effect on high Dark Triad superiors. We find supportive evidence that high Dark Triad superiors are greatly influenced by ex post discretion in setting targets but not in the effort they exert therein. These superiors set the most aggressive targets when they have ex post discretion but set even less aggressive targets than low Dark Triad superiors when they do not have ex post discretion.
We test our predictions using a 2 (discretion/no discretion) x 2 (missed/beat target) between-subjects experiment,with measured personality traits,administered tobusiness alumni via Qualtrics. Participantstake the role of a division manager with the task of setting a target for asubordinate and the opportunity to adjust their subordinate’s bonus after an uncontrollable event either negatively or positively affected the subordinate’s performance to target.
Our findings increase awareness that target-setting and compensation decisions do not happen in isolation, but are part of a cycle and influence each other. The individuals involved in the target-setting process are often the individuals performing evaluations and making compensation decisions. Accordingly, it is essential to understand how these processes and the individuals involved influence each other in order to further develop our understanding of their place in a firm’s management control system.
We furtherprovide several contributions to the accounting literature. First, we highlight a consequence of including discretion in compensation plans. With discretion, superiors can set more aggressive and potentially less complete targets (due to lower effort in setting the target), which can reducesubordinate motivation(Burt et al. 2015; Kelly et al. 2015), even in comparison with subordinates who receive the same target from a superior that does not have discretion(Kelly et al. 2015). Even if aggressive targets are adjusted ex post, continual target adjustment reduces the motivational effect of targets(Arnold and Artz 2015). These findings suggest that if ex post discretion leads superiors to set more aggressive targets, as our results show, subordinate motivation will suffer. If targets are used directly or indirectly to develop budgets, operating plans, or forecasts, the problems caused by aggressive targets set in tandem with discretion can be far-reaching. Not only are aggressive targets a potentially less accurate depiction of subordinate ability, but they also reduce motivation when they are set by a superior that has discretion, which widens the gap between the target and subordinate performance.
Second, our results illustrate that superiors are more likely to make compensation adjustments when they have ex post discretion than their expectation of making the change, if given the opportunity, showing that they are using this ex post discretion as a back-up plan.Past research documents superiors’ inclination to make upward adjustments to subordinate compensation for negative uncontrollable effects, but notdownward adjustments for similar positive effects(Garvey and Milbourn 2006; Bol and Smith 2011). We add to these findings, documenting that while superiors are less likely to make a downward adjustment to subordinate compensation for ‘good luck’ compared to an upward adjustment for ‘bad luck’, superiors who rely on ex post discretion as a back-up plan during the target-setting process are much more inclined to make such a downwardadjustment than are superiors who set targets ex ante without the benefit of ex post discretion, if given the opportunity.
Third, weprovide evidence that personality traits play an important role in superiors’ target-setting choices. Specifically, we find that high Dark Triad superiors are more affected by the compensation design than low Dark Triad superiors, resulting in even more aggressive targets whenhigh Dark Triad superiors have ex post discretion. This overall tendency towards more aggressive targets could exacerbate the negative effects on subordinate motivation.As high Dark Triad individuals tend to reach higher hierarchical levels within an organization(Judge et al. 2009; Babiak et al. 2010; Wille et al. 2013), the consequences of including discretion in compensation plans are likely more pronounced in the upper levels of an organization’s hierarchy.In addition, the generations entering the work force have higher levels of Dark Triad personality traits, which suggests that the upcoming pool of managers will generally set more aggressive targets when they have discretion. These effects are a facet that can be considered in the design of compensation plans and provides insight as to why compensation plans affect individuals differently.
The remainder of the paper is organized as follows: Section II develops the theory and hypotheses and section III explains the testing methods. Results are presented in section IV and section V concludes.
II.Theory and Hypothesis Development
Ex Post Compensation Discretion
Ex post compensation discretion is used by firms to reduce distortions and compensation risk and is especially important when organizational interdependencies are high, when a long-term investment focus is desired, and when bonuses are formula driven, difficult, and lead to severe consequences if not met (e.g., adverse effects on pay raises, promotions, continued employment, and/or budget funds)(Gibbs et al. 2004). Discretion is used when some aspects of performance cannot be captured using quantitative measures, such as when the subordinate’s job is complex, the operating environment is unpredictable, the firm has growth opportunities, quantitative measures are noisy or subject to manipulation, or the job requires soft skills(Baker, Gibbons, and Murphy 1994; MacLeod and Parent 1999; Hayes and Schaefer 2000; Ederhof 2010; Höppe and Moers 2011). Thus, ex post compensation discretion is a tool to reduce subordinate risk in multiple contexts.
Targets set by superiors at the beginning of the period (ex ante) can increase compensation risk,as it is impossible for superiors to perfectly predict what will happen during themeasurement period. Ex post compensation discretion allows superiors to remove the effects of unpredictable and uncontrollable events from the subordinate’s performance evaluation and incorporate relevant information that comes to their attention during the period, reducing the risk to subordinates. Thus, ex post compensation discretion can benefit both the subordinate, through lower compensation risk, and the firm, from enhanced incentive alignment and the ability to motivate subordinates to react to unanticipated events(Gibbs et al. 2005).