How Do Bonus Cap and Malus Affect Risk and Effort Choice? Insight from a Lab Experiment

Abstract

We conducted a lab experiment to examine how bonus caps and malus affect individuals’ choices of risk and effort. We find that a bonus structure that rewards individuals proportionally to realised investment returns, but does not penalise negative returns, encourages risk-taking; while a bonus cap and malus mitigate risk-taking. However, the difference in risk-taking between the bonus cap and malus treatment groups and the proportional bonus group weakened significantly when the participants’ bonus was conditional on hitting an absolute or relative performance target. We also find some evidence that the bonus cap discourages project search effort relative to the proportional bonus, whereas the difference in the levels of effort between the malus treatment group and the proportional bonus group was not statistically significant.

Keywords: bonus cap, bonus regulation, incentive pay

JEL Classification: C91, G28, G40, J33, M52