Intertemporal Framing Issues in Management Compensation

Abstract

This study investigates whether manager–decision-makers’ expectations about incentive compensation and environmental uncertainty influence investment decisions through their effect on the decision maker's implied discount rate. This is, to our knowledge, a first attempt to manipulate implicit risk, the risk to future payoffs associated with environmental uncertainty. Both these factors and waiting time are expected to influence implied discount rates. The study investigates discount rate influences under both bonus and penalty incentive plans. The hypothetical bonuses are year-end cash bonuses; the penalties are opportunity costs. Responses were analyzed using both analysis of variance and regression. The regression analysis was used to separate time discounting from the other factors affecting implied discount rates. Subjects’ responses to proposed changes in the timing of cash bonuses were dramatic when an expanding economy was suggested. However, subjects’ responses to penalty provisions were less dramatic than corresponding responses to the out-of-pocket negative outcomes studied in previous research. In some situations, penalty provisions may be more effective for inducing investment than bonus provisions. In addition, the results suggest that efforts to change management decision making using deferred compensation may require more deferred compensation than time discounting alone would require.