Compensation Committee Lessons From 2021

As of May 2021, this country is moving toward a more open, post-pandemic state of business. With this turn of events, what did the banking industry learn from the Covid-19 pandemic? What impact did the pandemic have on compensation plans? What worked, what didn’t and what were the implications for the compensation committee?

The move to a virtual meeting environment in 2020 clearly allowed the compensation committee to work through the pandemic. But while they’re clearly efficient, are these meetings as effective as possible?

In-person committee meetings often allow for preparations the day before and a number of instances to talk to other committee members before the actual meeting, generating questions to address before the meeting happens. When virtual, much of this preparatory time is often lost.

The question now is whether there should be a minimum number of in-person committee meetings, to balance effectiveness against efficiency. Should boards require that key meetings, either defined by length or subject matter, be in person? It’s your board’s question to answer — only you know if meetings have been more effective, more efficient or both in the past eighteen months.

Imbalanced Annual Incentive Plans
How did the bank’s performance plans perform in 2020? To answer that question, we need to first review the state of annual performance plans at the beginning of 2020. Most plans had between three to five performance metrics or goals that were typically a mixture of performance, deposit or loan growth, and credit quality.

Two primary trends arose by mid-2020. First, plans with a majority of their metrics based in performance often had issues. These would be plans that, for example, had 40% to 60% of the plan based on bottom-line metrics such as return on equity, return on assets, net income or earnings per share. Second, plans with a small number of metrics — two to three — also often had issues. These two issues meant plans either weren’t going to pay out in 2020 at all or were materially negatively impacted. This left the compensation committee with the task of using discretion to provide some level of payout if the foundational plan didn’t work.

In contrast, plans with four to six metrics and with less than 50% of their metrics based on profitability often didn’t need much discretion. Plans that had a combination of pre-provision net revenue and bottom-line profitability figures worked the best in 2020. In short, a true balanced scorecard hitting on a number of areas, versus a plan solely focused on profit, won the day in 2020.

Long-term Incentive Plans
What about long-term incentive plans? In a phrase, “It’s all relative.” Long-term incentive plans based only on absolute goals, using fewer metrics, had a greater risk of not vesting compared to plans based on peer relative goals.

Going into the pandemic, most banks used two to three metrics based on both absolute and peer relative metrics. Plans that had a portion, if not all, of the performance metrics relative to peers fared best. Peer relative metrics, by their design, are anchored in specific peer performance.

While absolute goals provide certainty to the specific measure, macro-shocks to the economy — of which we have had two in 15 years — generally eradicate any certainty. Absolute goals also have the added burden of needing an explanation as to why they are rigorous at the onset. Banks that used absolute goals either faced grants that were not going to vest, a restatement or both.

Sunlight in Disclosures
Many banks had an interesting year writing their Compensation Discussion & Analyses (CD&As) in their proxy statement to disclose that they used discretion in annual performance plans or other compensation programs. In addition, some used discretion and restated their outstanding equity awards.

When a compensation committee uses discretion, it generally has to disclose that in the CD&A. Firms that explained a cogent rationale for their adjustments and that generally paid less than target, even discretionarily, fared well during the 2021 proxy season. Firms that utilized discretion, paid more than they did in 2019 or more than target often had a harder time with their CD&As.

Compensation committees have great latitude in the use of discretion; however, as U.S. Supreme Court Justice Louis Brandeis wrote in 1913, “Sunlight is said to be the best of disinfectants.” This is an important point for compensation committees to recognize. For all the machinations in the committee meetings, it is good to remember this all must be disclosed at the end of the day.