Variable Pay: Is it for the Worker or the Firm?

Abstract

We develop a model of variable pay driven by the capital structure problem of the firm, as opposed to a problem related to the worker, on which the prior literature has focused. If workers face low unemployment risk, firms use more variable pay, and more leverage. With an agency problem embedded in the model, we show the opposite relationship between employment risk and variable pay can prevail. Using novel data from the banking industry, which contains information on variable pay across firms, we find support for our model, most notably, that capital structure can be an important motivation for the use of variable pay.

Keywords: Worker compensation, Job tenure, Leverage, financial institutions

JEL Classification: G32, G24, J33