Banks are challenged to attract and retain both key executives and key producers. While cash compensation plays a major role in this process, many community banks use nonqualified benefit plans, which provide supplemental retirement income as an attractive recruiting and retention tool.
According to the American Bankers Association’s 2013 Compensation and Benefits Survey, 64 percent of banks offer some type of nonqualified deferred compensation plan. These plans are limited to select management or highly compensated employees. Nonqualified plans are generally categorized as either defined benefit plans or defined contribution plans.
With different types of nonqualified plans available, how do you decide which plan your bank should provide?
In a typical defined benefit plan, the executive is promised a fixed dollar amount or percentage of final pay at retirement as the plan is designed to overcome a retirement shortfall or achieve a specific wage replacement ratio. The executive receives a stated amount (e.g. $50,000 per year) for a stated period of time (e.g. 15 years) beginning at separation from service, or a specified date or age.
Defined contribution plans vary in design. The executive’s deferred compensation balance might consist of all bank contributions, all executive contributions, or a combination of the two. Bank contributions might be predefined, such as a specific dollar amount or percentage of salary each month, or they may vary based on achievement of certain performance goals (often called performance-driven retirement plans). The deferral or contribution is credited with interest by the bank and the accrued amount is paid beginning at separation from service or a specified date or age.
On the surface, it may seem that the performance-driven designs provide more alignment of the executive and shareholder interests; however, that may not be the case for the following reasons:
- Executives generally prefer defined benefit plans over performance-driven plans. The defined benefit plans provide a base level of retirement income to supplement the variable/uncertain amount of retirement income from the executive’s 401(k) plan and stock awards. The executive may favor the employer that offers the defined benefit SERP and may be willing to take a lower retirement benefit because of the higher degree of certainty.
- Once implemented, properly designed defined benefit plans are easy to administer and the expense can be budgeted for years to come.
Both benefit plan types require various terms and conditions to be documented in a contract between the bank and the executive. The contract should provide strong retention hooks, as described in a recent Bank Director article.
A couple of recent examples will help illustrate the board’s rationale for the implementation of both types of SERP:
Bank A conducted a nationwide search to hire a CEO. As part of the CEO’s compensation package, the board of directors agreed to provide a SERP designed to replace 70 percent of his final compensation, after taking into consideration his 401(k) and social security benefits. The board considered various alternatives but believed the defined benefit SERP was the most effective method to achieve its objective. Since the executive was only 50 years old, he would earn the SERP over the next 15 years. The executive was incentivized to take the position, in part, because of the promise of a stable retirement income, which would allow him to focus his energy on bank performance. In addition, the executive was provided with restricted stock that would provide alignment of the executive’s and shareholders’ interests. Lastly, the board favored the stability of expense the defined benefit SERP provides and the fact that the design does not promote excessive risk-taking.
At Bank B, the board felt strongly that supplemental executive retirement benefits should be provided using a performance-driven design. The board believed that to maintain a high-performance culture that aligns management and shareholder interests over the long-term, a defined contribution approach was the best fit. The plan provided that annual contributions would be measured based on performance targets established by the board. To provide additional protection against excessive risk-taking, the benefit payments would not begin until age 65 and would be payable in monthly installments over a 10-year period. All benefits would be forfeited if the executive was terminated for cause, if there was a material misstatement of the financial statements, or if the executive competed with the bank after termination of employment.
There is no one size fits all approach with regard to nonqualified benefit design. The facts and circumstances of the case, including bank culture and objectives, will dictate the best design for any given bank and executive. For more information on this topic, please see: “Is Your Compensation Plan Generous Enough?”
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