While banks continue to have challenges with low interest rates and slow loan growth, two issues are always critical: (1) the need to attract, retain and reward executive talent and (2) the need to consistently optimize earnings.
Many bankers put compensation and retirement discussions on the back burner for the past four or five years, but are showing a renewed interest in these programs as the crisis has eased. While salary, annual performance bonuses and equity plans are important elements to consider in a compensation plan, many banks have been offering nonqualified plans to help balance the total compensation plan for key executives.
If a bank upgrades its executive compensation and benefits to compete for outstanding talent, won’t the additional cost reduce earnings? Not really. When you are able to attract and retain key officers, the bank can expect to be rewarded with superior performance and increased earnings. Additionally, banks can generally offset these unfunded benefit liabilities with the tax-advantaged earnings from bank-owned life insurance (BOLI).
There are several types of nonqualified benefit plans and unlimited benefit and contribution formulas as well as performance-based strategies that can be incorporated to meet board approval. Where do you begin?
Begin by Understanding Your Shortfall
By design, qualified plans regulated by ERISA (the Employee Retirement Income Security Act) do not provide top executives with sufficient retirement benefits and do not reflect the shareholder value they create. Salary caps, the virtual elimination of defined benefit pension plans and the relatively low level of 401(k) matching contributions typically limit executives’ retirement benefits to 30 to 50 percent of final pay. Knowing the extent of your shortfall (amount needed at retirement compared to estimated amount available) is vital to the design of an effective nonqualified plan.
Regulatory guidance says that the overall compensation package must be reasonable; therefore, SERPs and other nonqualified plans should take into consideration other compensation being provided.
Prevalence of Nonqualified Plans
Such plans are common in the banking industry. According to the American Bankers Association’s 2012 Compensation and Benefits Survey, 68 percent offer some kind of a nonqualified deferred compensation plan for top management (CEO,C-Level, EVP), and 43 percent of respondents offer a SERP.
Nonqualified Plan Basics
- Supplemental executive retirement plans (SERPs) can be designed to address an executive’s shortfall. Generally, under the terms of a SERP, an institution will promise to pay a future retirement benefit to an executive, separate from any company-sponsored qualified retirement plan.
- Deferred compensation plans (DCPs) minimize taxation on base salary and bonuses by allowing executives to make elective deferrals into a tax-deferred asset. The bank can also make contributions to the executive’s account using a matching or performance- based methodology.
- Performance-driven benefit plans tie the bank’s overall objectives to an executive’s measurable performance. As these plans are based on reasonable performance benchmarks critical to the bank’s success, they address corporate governance concerns by increasing compensation only when objectives are met. Part or all of the distributions are made on a deferred basis for a variety of reasons.
- Split-dollar plans allow the bank and the insured officer to share the benefits of a specific BOLI policy or policies upon the death of the insured. The agreement may state that the benefit terminates at separation from service or it may allow the officer to retain the life insurance benefit after retirement if certain vesting requirements are met.
- Survivor-income plans/death benefit-only plans specify that the bank will pay a benefit to the officer’s survivor (beneficiary) upon his or her death. Typically, the bank will purchase BOLI to provide death proceeds to the bank as a hedge against the obligation the bank has to the beneficiaries. The benefits are paid directly from the general assets of the bank.
How Banks Use BOLI to Offset the Benefit Expense
The cost of each of the above plans varies by type and design. BOLI is a tax-advantaged asset whereby every $1 of premium equates to $1 of cash value on the bank’s balance sheet. Basically, BOLI is an investment asset that generates a return currently in the range of 3.00 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 4.84 percent to 5.65 percent (assuming a 38 percent tax bracket). From an income statement standpoint, the cash surrender value (CSV) is expected to grow every month. Increases in the CSV are booked as non-interest income on a tax preferred basis. From a cash flow perspective, BOLI is a long-term accrual asset that will return cash flow to the bank upon the death of the respective insured(s).
As an example, let’s assume a 50-year-old executive will be provided a $100,000 per year nonqualified benefit payment for 15 years at age 65. The annual pre-retirement after-tax cost averages $47,000 per year. The bank could invest $2 million into BOLI to fully offset the annual after tax benefit cost.
While bank challenges still remain, providing a balanced and affordable compensation plan that includes nonqualified benefit plans can help make a difference for growing shareholder value.
Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.