Are you better off with or without them? That is a question advice columnist Ann Landers asked her readers. The answer is even more relevant when discussing key employees of community banks. As we emerge from the Great Recession, employee retention remains a primary focus. In a recent Bank Director survey, 40 percent of bank boards identified retaining key employees as a significant challenge. In fact, 44 percent of banks nationwide lost key executives or critical employees in the past three years.
What can banks do to retain key employees? Prior to the financial crisis, conventional wisdom accepted equity grants as the best method to retain executives and tie compensation to performance. Then came the economic downturn and those same equity grants looked like a reason for the lax credit policies whose aftermath continues to bedevil banks. Remember, many executives that received those rather large equity grants were approaching retirement age as the first wave of baby boomers. Their opportunity to benefit from equity grants had to be realized in a relatively short period of time, creating pressure for ever increasing earnings and price appreciation. History shows it did not turn out as expected.
Now, let’s reconsider a popular executive compensation benefit that fell out of favor in the wake of media and shareholder outrage. Prior to the economic downturn, many banking executives benefited from a supplemental retirement plan in addition to the company pension plan or 401(k) plan. These Supplemental Executive Retirement Plans (SERPs) were intended to provide benefits to replace the limitations imposed by Internal Revenue Service regulations. As a retention tool, SERPs are extremely effective. Typically SERPs require the executive to stay until retirement age to receive the benefit. For example, a SERP may provide an annual benefit for the executive of 40 percent to 60 percent of salary for up to fifteen years after retirement. In the event the executive leaves to work for a competitor, the SERP is forfeited. The primary objective of all compensation plans—to influence the decision making of the employee—is achieved with a SERP.
Is the expense worth it? Yes. For illustration purposes, let’s assume a bank has a SERP with a benefit of $100,000 per year for 15 years. The total cost to the bank is $1.5 million. Although spread over many years, it is still perceived as expensive. The cost on an after-tax basis is about $900,000 assuming a top tax rate of 40 percent. In an environment of detailed compensation disclosure, this seems excessive. But is it really?
Let’s look at the terms SERPs impose. First, executives must be employed with the bank until retirement. The bank is the guarantor of the benefit, not a third party as in the case of a 401(k) plan or a pension plan. For rank and file employees, if the bank fails, their retirement plan is guaranteed by a third party or the Pension Benefit Guaranty Association. With a SERP, the bank is the guarantor. If the bank fails, there is no one to make the payment and the executive loses the promised retirement benefit. Similarly, if the bank fails after the executive’s retirement, there is no one to make the payments.
One of the responsibilities of any manager is to develop talent to eventually succeed him or her. In this scenario, a 50-year old executive granted a SERP must focus on protecting shareholder value until retirement (age 65) and ensure the successor is capable—and motivated—to do the same. Thirty years is not a bad deal in exchange for a cost of $900,000.
When properly designed, the benefit to the bank and shareholders is greatly in excess of the cost of a SERP. Heidrick & Struggles, an executive search firm, says an incoming executive takes up to 18 months to achieve the level of productivity he or she provided prior to accepting a new position. This cost combined with what is known as the lost opportunity cost of not having a fully effective executive in a critical position makes the cost of a SERP appear minimal.
Top executives drive shareholder performance. If retaining these key employees is important to your bank’s future, then now is the time to make sure your bank doesn’t become one of the 44 percent who lost a key employee.