Incentive Plan Adjustments in the Current Challenging Environment

2023 continues to be a challenging year for financial institutions. While banks planned for interest rate increases, few expected bank failures or immense pressure on deposit pricing. The recent bank failures and lower profitability outlook has been priced into the stock market, with the KBW Nasdaq Bank Index down nearly 20% year to date.

As a result, annual incentive payouts are trending lower than in recent years and the value of equity holdings has diminished at many banks. Award payouts are likely to be between threshold and target levels. The talent market, which has cooled somewhat, remains healthy and will pressure compensation committees to consider an appropriate balance of accountability, fairness and retention in incentive plan determinations.

2023 Annual Incentive Plans
Most compensation committees are taking a wait-and-see approach, given the continued uncertainty for the rest of the year. While they may be able to defend making certain adjustments now, companies generally get one opportunity to make a change. If banks modify their goals midyear and the institution’s financial performance worsens, it would be very challenging to justify further adjustments or use discretion at year-end.

We expect a variety of outcomes for 2023 annual incentive plans. We do not expect changes to the metrics or plan design at banks with incentive plans that use performance metrics that are less impacted by the interest rate volatility or have a discretionary component. However, for incentive plans that have been significantly negatively impacted, we may see year-end discretionary adjustments or broad use of strategic or individual components that place performance in the context of the external environment and provide payouts that are reflective of management’s action in 2023. Any discretionary decisions are likely to result in modest and below-target awards, given reduced bank earnings and negative shareholder returns.

There are several questions for the committee to consider in determining the use of discretion:

• Should the same payouts be provided to the executives as to the broader participants?
• Did management take effective actions in response to the challenging external environment? Could the risks have been managed more effectively?
• Have other adjustments been made to the plan in recent years (for example, reducing payouts when external factors increased earnings)?
• How did the bank perform on a relative basis versus industry peers?
• How will the adjustments or discretionary payouts be described in the proxy? Does the justification provide sufficient support for the ultimate payout levels?
• How is the bank expected to perform on proxy advisors’ quantitative tests? If lower results are expected and scrutiny is likely to increase, is the committee comfortable with shareholder outreach and defending the decision?
• How has the bank accrued for the bonus and what level of payout is affordable?

Outstanding Performance Shares
Unlike annual incentives, it can be more problematic for the compensation committee to adjust long-term awards with vesting that is contingent on achieving financial or shareholder return goals. Modifying these awards may lead to increased expense costs and disclosure requirements, as well as substantially more shareholder criticism and Say-on-Pay issues. Fortunately, many banks use relative performance metrics, which, by their nature, automatically adjust for macroeconomic circumstances. As a result, we anticipate few banks will modify outstanding performance shares unless applicable language is currently built into their performance metric definitions.

Determining award payouts in 2023 will be a combination of results and compensation committee discernment. Compensation committees should review the banks’ incentive plan language and determine the extent of flexibility, discretion and adjustment permissible. A robust dialogue, using the considerations above, will aid in striking an appropriate balance of accountability, fairness and retention.