In the absence of final guidance from regulators on incentive compensation risk (Section 956 of the Dodd-Frank Act), the Federal Reserve is actively driving for changes in compensation practices and incentive use among the largest banks as part of its goal to mitigate risk-taking. Following adoption of joint regulatory guidance on incentive compensation approved by all banking agencies in June 2010, the Federal Reserve undertook a “horizontal” review of the 25 largest and most complex banking organizations. While the process has been ongoing, over the last year, the Fed has expanded its focus on the next tier of larger regional banks. We have learned much through this process that may change practices across the banking industry.
What are the themes coming from the Federal Reserve’s review of the largest banks and how might they influence bank compensation programs?
- Adjust Incentives for Risk: Whether payouts are discretionary or formulaic, regulators want to see incentive awards adjusted or deferred to better account for risk. Appropriate techniques include adjustments to the incentive “pool” or to specific awards. Deferral of awards is another appropriate approach when annual incentives comprise a significant portion of the pay package and/or are based on results that may change after the performance period. Deferral payouts are typically subject to additional performance criteria.
- Reduce/Eliminate Stock Options: Stock options have been attacked in recent years by many constituencies for various reasons, among them the view of regulators that they have the potential to drive risky behavior. But eliminating options altogether is a topic of debate among many compensation committees. Some believe options help align executives with shareholder value. The reality is that providing a very significant majority of pay in the form of stock options can motivate risk, but that used in smaller proportion, options are an appropriate vehicle within an overall portfolio of risk-balanced incentives.
- Limit Upside Leverage: Major shareholders and advisory firms like Institutional Shareholder Services have focused in recent years on driving stronger pay-performance alignment. However, regulators have expressed a preference for lower upside rewards for achieving performance above target, which can reduce the incentive for strong performance. Many of the largest banks have responded by reducing the caps on incentive pay to 150 percent of the target incentive, down from as much as 200 percent of target. It remains unclear what other program changes will be made over time to accommodate the regulators’ changes to program design.
- Reduce/Eliminate Relative Performance: Regulators have also indicated their distaste for incentive awards that are based on relative performance—a narrow and prescriptive view that appears to be receiving more resistance from banks, for good reason. While short term plans typically focus on absolute goals that reflect annual budgets, long-term incentives often employ a three-year performance period. The problem is that the current economic and banking environment has made setting long-range goals a near impossibility. If banks are prohibited from considering relative performance, the unintended consequence is likely to be less challenging performance goals. In addition, because long-term plans often pay out in stock, to better align with shareholder value, consideration of a bank’s performance relative to industry peers is a valid perspective. That said, relative performance alone and without proper protections (e.g. performance gates) can result in inappropriate payouts. For example, at the start of the financial crisis, some banks rewarded for three-year total shareholder return (TSR) relative to a peer/industry index, such that higher rankings resulted in greater awards. Because those plans failed to account for the trend toward negative shareholder return, however, they also resulted in some high payouts for declining value—for being the best of the worst. Rather than eliminating relative performance altogether from long-term plans, banks should focus on better designed plans with features and discretionary adjustments designed to avoid such outcomes.
- Define Discretion: Discretion remains a legitimate and appropriate means for adjusting pay and making award decisions in response to special circumstances, including the need to maintain sound risk management. However, the Securities and Exchange Commission and shareholder advisory firms are pushing companies to more clearly document and communicate the factors that were considered when discretion was employed in award payouts.
In the end, resorting to prescriptive or one-size-fits-all compensation designs will not meet the ultimate objectives regulators are seeking. Compensation programs must seek balance between:
- Fixed and variable /performance pay
- Cash and equity
- Short and long-term perspective
- Absolute and relative performance
Risk-taking generally results when performance-based plans are overly focused on a particular component of pay, or on a specific measure, rather than a broad view of performance. A compensation program that balances the elements outlined above and provides a sound portfolio approach to incentives will be far less likely to drive inappropriate or excessive risk-taking, ultimately promoting good pay-performance alignment.