Fairness and Luck: Contract Away or Come What May?

Abstract

ABSTRACT Prior research shows that managers use discretion to reduce the effect of “bad luck” on employees’ performance-based compensation, but not to reduce the effect of “good luck,” due to fairness concerns. In a setting without manager discretion, we investigate whether objective compensation plans that account for luck can be used to reduce fairness concerns. We show that although such compensation plans are perceived as fairer ex ante, they do not produce uniformly higher perceived fairness ex post. Individuals who experience bad luck believe their compensation is fairer if the compensation plan limits the effect of luck on their compensation than if the compensation plan allows luck to influence their compensation. In contrast, individuals who experience good luck believe their compensation is less fair if the compensation plan limits the effect of luck on their compensation. These findings highlight the complex relationship among incentives, employee selection, retention, satisfaction, and motivation. JEL Classifications: D8; J3; M52.