Bonus payments for high-earners have tended to be justified as being necessary to avoid even higher salary levels and losing talent.

The dispute this year between the state-backed Royal Bank of Scotland and the Treasury is typical of the arguments involved: RBS wanted to offer bonuses of up to twice the size of salaries; George Osborne argued that the bonuses didn’t reflect the financial performance of the organisation, and more generally, that out-of-control bonuses were part of the culture that had led to the financial crisis in the first place. In response, RBS claims it will be unable to keep the ‘top’ staff it needs to deliver the turnaround plan and even better performance for the Treasury.

With the ongoing controversy over bonuses it’s important we better understand how bonuses work. Media tend to highlight the size of bonuses paid in financial services, often using negative phrases such as ‘bonus culture’ that suggest the payment of something for nothing. Bonuses have become symbolic of greed and inequality. The depth of public feeling regarding bonuses has led to pronouncements by both the US president and the UK prime minister on the need to restrain “inequitable payments” and proposed legislations to cap bank bonuses in the EU.

In principle, these perceptions seem at odds with the basic theory that bonuses, like other forms of performance pay, stands in lieu of some portion of an otherwise riskless (or at least less risky) salary payment, and so serve to increase firm profitability and employee performance. The idea that high performance bonuses substitute for salaries provides the basis for the resistance by both the UK and US financial sector to cap or reduce bonus payments.

Previous research demonstrates that bonus payments are highly concentrated in the upper levels of the income distribution. While the size of bonuses for financial service workers gets the attention, other research has demonstrated that more performance pay in the US is associated with increased earnings inequality over the 1980s and 1990s. Our work has examined the implicit trade-off between the size of bonus payments and salary payments. Do bonuses substitute for salary – or are they just ‘gravy on top’? Our UK study is timely in light of OECD research that earnings inequality is growing more quickly in the UK than in any other developed country, and the evidence that this growth is uniquely tied to the financial services industry with its use of performance bonuses.

The data we use are drawn from the British Household Panel Survey (BHPS). The BHPS is a nationally representative longitudinal sample that annually interviews approximately 10,000 individuals from roughly 5,500 households. We limited our sample to private sector employees. The BHPS contains a range of information on earnings, including bonuses and profit share within the last year. The size of the average bonus among recipients is £3,180. The real value of bonuses among recipients has increased substantially over the decade, reaching a high of £5,400 in 2007, but declines substantially the next year in the wake of the financial crisis.

A key problem with isolating the relationship between salary and bonuses is that it’s well known that performance pay attracts more able workers, in fact this is at least part of their purpose. So naturally, these workers get paid more, and are more likely to receive (larger) bonuses. In our approach we emphasize the importance of using repeated observations of the same worker to control for worker ability. Specifically we were interested in how payment of bonuses for a given worker is associated with their salary payment. We also looked at the relationship between bonus payments and salaries across the wage distribution.

We found no evidence of there being any trade-off between salary and bonuses for high-earners – in other words, it’s not a case of bonuses being used to top up a lower salary, they look like an added ‘gravy’. For lower earners, the figures showed that they are a different case – and they do forgo an element of salary payments in order to receive bonuses. They give up 40p of their salary for every £1 in bonus.

It’ll be important to dig more deeply into the issue and the figures. So data sources from other countries that itemize the size of bonuses might be worth investigating, as well as other forms of performance pay beyond bonuses. If there’s to be a useful debate over salaries vs bonuses, and ‘reasonable’ or appropriate levels of bonuses, then HR and rewards professionals need this level of clarity and understanding of the actual nature and workings of additional payments, whatever form they take.

Professor Colin Green, Lancaster University Management School,