Incentives as risk instruments: why risk matters more than reward

Most people think incentives are reward mechanisms. Increasingly, I think it is more accurate to view them as risk instruments.

That may sound like an odd distinction, but it helps explain why so many debates about executive remuneration seem to generate more heat than light.

We tend to assume that incentive arrangements exist primarily to reward success. Pay someone enough and they will perform. Pay them more and they will perform better.

This framing is not exactly wrong. But it is incomplete.

Many of the most consequential incentive decisions are not really exercises in reward design at all. They are exercises in risk pricing. Once that distinction is understood, a number of remuneration arrangements that appear difficult to justify begin to look rather different. Some remain difficult to justify. But the analytical lens matters.

The risk pricing principle

Higher-risk investments demand higher expected returns. Equity investors expect greater upside than lenders because they bear greater uncertainty. Private equity investors target higher returns because they accept illiquidity, concentration risk and the possibility of loss.

In each case, the reward is not simply payment for performance. It is compensation for accepting risk.

Executive remuneration is often analysed differently. Large awards are typically viewed through the lens of reward and judged against past performance. What that approach can overlook is the risk an individual has accepted in order to be in a position to earn that reward at all.

So is there another way to look at incentives?

Rather than viewing them purely as compensation structures, perhaps it is more helpful to view them as mechanisms for allocating risk and reward. The organisation provides the platform, capital and opportunity. The individual contributes skill, judgement and a willingness to accept uncertainty. The incentive arrangement determines how the value created by that relationship is ultimately shared.

Viewed in that way, many debates about executive pay become less about the size of the award and more about whether the allocation of risk and reward is appropriate.

Replacement wealth versus new wealth

One of the most misunderstood features of executive pay is the role of buy-out awards.

When a senior executive moves organisations, they commonly leave behind significant value. Suppose an individual forfeits £2 million of unvested share awards, £500,000 of deferred bonus and approximately £1 million of future vesting opportunities. A recruitment award of £3.5 million may attract substantial criticism in isolation. Economically, it may do little more than restore the individual to the position they would have occupied had they stayed put.

That does not make every replacement award justified. Boards can and do use buy-outs to create value transfer that goes well beyond genuine replacement. Weak performance conditions, inflated valuations and rewards structured to vest regardless of outcomes all deserve challenge.

But the analytical starting point should be accurate. The question is not simply how large the award is. It is how much of that award represents new wealth and how much represents the restoration of foregone value. The two categories are not the same and treating them as equivalent produces misleading conclusions.

The value of uncertainty

One feature of incentive awards is often overlooked. 

Two awards with the same headline value may have very different economic value. The reason is simple: the value of an incentive depends not only on the potential upside, but also on the likelihood of achieving it. 

Consider two executives receiving identical equity awards.

One joins a stable, successful business with a clear growth trajectory. The other joins a business facing operational challenges, strategic uncertainty and a demanding turnaround programme. 

On paper, the awards may look identical. In practice, they are not. 

The second executive faces a much greater risk that the award will ultimately deliver little or no value. As the probability of success falls, the potential upside required to justify accepting the role typically increases.

Private equity has long recognised this principle. Management teams are often asked to accept significant uncertainty in exchange for the possibility of substantial future value creation. The equity they receive is not simply a reward. It is compensation for accepting a risk profile that many others would reject. 

The same logic applies more broadly across incentive design.

The more uncertainty a participant is being asked to accept, the more valuable the opportunity generally needs to be.

That helps explain why incentive arrangements associated with turnarounds, transformational change or high-growth opportunities can appear unusually generous. They are not necessarily pricing certainty of success. They are pricing the possibility of failure.

The counterarguments

None of the above is a defence of executive pay as currently practised.

The risk-pricing framework has real explanatory power, but it also has limits and those limits are frequently exploited.

The most obvious problem is asymmetry. Genuine risk-sharing requires that executives bear meaningful downside as well as upside. In practice, many arrangements are structured to soften or eliminate that downside. Golden parachutes pay executives when they fail. Targets are reset when they are missed. Peer groups are selected to flatter relative performance. Base salaries and pension contributions provide a comfortable floor regardless of outcomes.

An incentive structure that captures upside without genuine exposure to downside is not really a risk instrument. It is a one-way bet and the risk-pricing argument cannot justify it.

There is also the scarcity argument, which is invoked frequently but deserves more scrutiny than it usually receives. The claim that truly exceptional leadership is rare and commands premium compensation is plausible in theory. But the evidence that executive pay reliably identifies and rewards that exceptional leadership - rather than simply reflecting negotiating leverage, incumbent advantage and benchmarking conventions - is considerably weaker.

Boards that invoke scarcity as justification for large packages owe shareholders a more rigorous account of what exceptional leadership looks like in their specific context and how they have assessed whether the individual in question provides it.

What good governance actually requires

The headline figure is rarely the most informative number.

Better questions include: how much of the award is genuinely at risk against outcomes the executive can influence but not control? How much is replacing value surrendered elsewhere? What performance must be delivered before significant value is realised and how stretching is that bar? What happens if the strategy fails - does the executive share meaningfully in that failure? How closely are management and shareholder outcomes actually aligned over a realistic time horizon?

These questions will sometimes lead to the conclusion that a large package is well-designed and commercially defensible. They will sometimes reveal that the headline number is the most honest thing about it.

Ultimately, this question extends well beyond chief executives.

The same economic logic sits beneath growth shares, management incentive plans, carried interest structures, founder equity arrangements and long-term incentive plans. Although the legal frameworks differ, they are all attempting to solve the same fundamental problem:

How much upside is required to persuade an individual to accept risk, uncertainty and delayed reward in pursuit of future value creation?

The answer will vary from one situation to another. A founder rolling equity into a private equity transaction faces different risks from a FTSE chief executive accepting a turnaround mandate. A management team investing alongside a sponsor faces different risks from an employee participating in a growth share plan.

Yet the underlying economics remain remarkably consistent.

The best incentive plans do not simply distribute reward. They allocate risk. They determine who participates in success, who bears uncertainty and how value is shared when things go well and when they do not.

That is why the headline value of an award is often the least interesting thing about it.

The more revealing question is how the risk has been allocated.

Understanding that distinction frequently tells us far more about the quality of an incentive arrangement than the number attached to it.

At Burges Salmon, we advise boards, investors and management teams on executive incentive design across listed companies, private equity-backed businesses and privately owned groups. Our work consistently returns to the same challenge: creating structures that allocate risk, reward and long-term value creation in a way that is commercially credible and genuinely aligned with shareholder objectives.