Performance Pay and Risk Sharing between Firms and Workers

Using data from Glassdoor, we show that firms transmit productivity shocks to workers through performance pay. Performance pay responds more than base to industry shocks, falling (rising) 17% in Finance (Information Technology) after the recent financial crisis. At the regional level, performance pay is 7--10x more procyclical than base pay, and this procyclicality is strongest among larger firms in tradable industries. Idiosyncratic shocks to annual firm performance also pass through to bonuses, with a one-standard-deviation increase in average labor productivity raising performance pay by 5%. We rationalize these results in a model of risk sharing between a worker with limited commitment and a risk-averse firm. Consistent with our theory, performance pay usage is associated with increased earnings variance for workers, but lower volatility of firm sales, employment, and productivity growth. Interestingly, it is also associated with faster productivity growth, suggesting that incorporating performance-based compensation may help improve firm performance