Incentive Compensation – The White Swan in Risk Management

In his book The Black Swan, the Impact of the Highly Improbable , Nassim Nicholas Taleb describes three key attributes of a black swan event. First, it is an ‘outlier’ event, one outside the realm of regular expectations. Second, it carries an extreme impact. And third, because of its outlier status, human nature leads us to develop after the fact explanations for its occurrence, making it explainable and predictable. In my view, an event underlying incentive compensation ('Incentive Compensation event') has three entirely opposite attributes to those of a black swan event. Incentive compensation payout which is a consequence of the event (e.g., meeting or exceeding performance threshold, or implementing a strategic objective) is in the realm of regular expectations since the payouts can be reasonably estimated, and the payouts are explainable and predictable prior to the event occurring (threshold targets are set at a level where the maximum payout is determinable). Interestingly, a black swan event results in extreme downside losses, whereas an incentive compensation event tends to result in massive upside payouts. Thus, incentive compensation events have opposite attributes to those of black swan events; from a risk management perspective, we can label incentive compensation as white swan events.