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Efficient Risk Bearing and Incentives in Compensation Plans

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Efficient Risk Bearing and Incentives in Compensation Plans
Efficient risk bearing hints that it is better to give employees fixed salaries, while incentive considerations lead to the conclusion that it is better to tie pay to performance. (Brickley, Smith, and Zimmerman, 2009). Thus a well-designed compensation plan should be able to reflect the trade-offs between these two.
Employees typically are risk-aversion. They do not have full control over their outputs. In addition to employee efforts, the overall performance of the company greatly depends on random outside events, such as the global economic and financial environment and the stability of the market and so on. Adding that employees largely rely on their income, which is normally gained from one firm, they care about the fortunes of the firm and cannot be fully accountable for their actions. As a result, appointing employees to fully share the operational risk is not efficient. When the owners of the firm have a comparative advantage in bearing firm related risk, from an efficient risk bearing point of view, it is better to provide employees with fixed salaries.
On another hand, incentive compensation is likely to increase the effort of the employee which can increase these gains from trade. Incentive problems exist within firms that the interests of employees and employers are not aligned perfectly. Fixed salaries do not provide strong incentives. There’s a trade-off between incentive compensation which aims to motivate employees and reducing inefficient risk bearing costs.
As a result, firms often use compensation plans combined fixed salaries with one or more variables based on performance. Economists have been trying hard to work out effective plans. Nevertheless, there are also doubts on whether or not incentive compensation works. Alfie Kohn has offered analysis on reasons for the failure of incentive programs. He states that incentive rewards “have failed to offer a convincing argument for behavioral manipulation”. (Kohn,

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