*This article was published in Bank Director magazine’s third quarter 2024 issue.
No board or management team believes they can perfectly predict the bank’s business operating environment for the year ahead. Yet, executive incentive scorecards are established early in the year with the intention that they motivate performance without the need for in-flight modifications.
Are there ways for boards to preserve the pay-for-performance integrity of their plans, while simultaneously providing levers that can enhance flexibility, maintain motivation and result in a balanced assessment?
Here are four considerations for compensation committees.
1. Allowance in the Plan Document
Nearly all executive annual cash incentive plans provide the compensation committee with absolute discretion to interpret, administer, modify, withhold, increase or decrease payouts under the plan.
This manifested uniquely in 2023, when an unprecedented number of banks chose to modify preestablished performance metrics. For some, this included adjustments to exclude accumulated other comprehensive income, or AOCI, or the unanticipated special Federal Deposit Insurance Corp. assessment from performance plan metrics.
Of course, these decisions have implications. However, for annual incentive plans, committees can, very appropriately, make whatever decision they deem best given the facts and circumstances.
2. Discretion’s Role in Risk Management
In their evaluation of incentive-based compensation practices, regulators have long viewed discretion as a key tool to help boards appropriately balance risk and reward. It has become even more clear in recent years that risks cannot be managed solely through the right mix of goals and a proper payout trigger. Discretion remains a unique and necessary lever, though in this context, it is one that most commonly results in a downward adjustment to incentive awards based on adverse events. This is a process and governance feature as much as it is a plan design feature.
3. Disclosure and Shareholder Perception
Public banks face ever-increasing scrutiny from shareholders who expect a transparent and compelling description of the committee’s assessment of performance. The level of scrutiny has been heightened somewhat following the widespread use of discretion during the pandemic. While shareholders are not necessarily against subjectivity, they do not typically give the benefit of the doubt. They do not want discretion used as forgiveness, and they do not have an appetite for adjustments to offset core banking issues, e.g., interest rate environment or credit issues.
Downward adjustments are not generally in the shareholder spotlight, but upward discretionary modifications or subjectively assessed performance categories paying at, and especially above, target demand a thoughtful and robust explanation.
4. Identified Discretion Areas
Directors want flexibility in payout decisions — especially during years of economic uncertainty. It may seem wise to tag a portion of the plan for board discretion, assessed based on the subjective evaluation of performance across strategic, operational or other factors. While the practice varies by bank size, some banks carve out 10% to 20% of the plan for this purpose. Others use a payout modifier. Regardless of the construction, directors often struggle with how to approach discretion. Without expectations and a defined framework for evaluating this category, directors very often default to target or target-plus payouts, which diminishes the usefulness of this category.
A balanced approach brings structure in two ways:
Identify goals but retain flexibility. Banks should identify goals and areas of focus within this category at the beginning of the year. They should be defined well enough to allow the committee to determine rigor and what success looks like.
Midyear update: The committee should receive a midyear update from management to understand progress toward attainment. A midyear check-in promotes accountability, identifies remaining focus areas for the year, manages expectations and provides a touchpoint for feedback. It also provides an opportunity for limited adjustments or recalibration of priorities, if appropriate, based on unanticipated market events or internal factors. This is often a missing step and yet is foundational to maintaining both integrity and flexibility.
The committee’s goal should not be to completely insulate annual incentive plans against unpredictable events or to ensure that target-level payouts are likely to be attained each year. However, thoughtfully designed plans with a structured and balanced approach to discretionary decision-making can help preserve plan effectiveness even in times of uncertainty.
