Incentive plans are a critical component of a bank’s compensation program. They help drive business results, provide competitive compensation opportunity and ensure an appropriate linkage between pay and performance. For publicly-traded banks, disclosure of incentive plans also serves as an important communication to shareholders of the bank’s priorities and commitment to pay-for-performance. With 2014 just around the corner, now is the time to determine the appropriate structure of your incentive plans for the new year.

Annual Incentives

Annual incentives help drive business results by linking compensation to the accomplishment of annual goals that support strategic priorities and ultimately create shareholder value. Key objectives of annual incentive plans include:

• Driving business strategy – The choice of incentive measures and performance goals communicates to participants the results, behaviors and success factors needed to achieve business objectives. Banks should review their incentive plan measures each year to ensure they are aligned with the business plan and driving progress toward long-term goals.
• Rewarding performance – Annual incentives should ensure that executives are appropriately rewarded for results. Plans should have threshold, target and maximum performance levels, with appropriate leverage in the payout ranges to ensure that reward levels are appropriate for the performance achieved (whether above or below expectations). Historical payouts should be assessed to determine if the plan is resulting in an appropriate pay-performance relationship.
• Mitigating excessive risk taking – Bank regulators are focused on ensuring incentive plans, measures and payouts ensure participants are not incentivized to take excessive and/or inappropriate risks. This assessment should be conducted annually and whenever a new plan or changes are being proposed.

Choosing the right performance measures is essential to ensure that annual incentives support the key business objectives. While earnings (e.g., earnings per share, net income) is the primary focus for most bank annual incentive plans, including additional measures ensures a more balanced plan and provides the opportunity to directly link incentives to strategic priorities. Depending on a bank’s priorities, it may be appropriate to focus on growth, expense control, capital levels and/or credit quality.

It is also important to consider to what extent the annual incentive plan will reward performance at the company, business line and individual levels. Typically, a higher percentage of annual incentives are based on bank-wide results for senior executives to reinforce the team approach. Incentive plans also can provide some level of individual accountability by allocating goals specific to each executive’s role. Executives should meet to discuss their respective individual goals for the upcoming year to ensure appropriate coordination and interaction as needed.

Long-Term Incentives

Long-term incentive plans, which are typically delivered primarily through equity awards, should motivate and reward the creation of long-term shareholder value. Long-term incentive plans do this by enhancing alignment with shareholders, rewarding sustained long-term performance and creating retention “hooks” for high performers through the value of unvested awards.

Banks can choose from a variety of vehicles to deliver long-term incentives, including time-based restricted stock, stock options, performance shares (restricted stock that requires achievement of performance goals to vest) and long-term cash plans. Each vehicle has its own strengths and weaknesses in accomplishing the objectives of long-term incentive programs. Stock options and performance shares promote shareholder alignment and performance, while time vested restricted stock promotes stock ownership and retention goals. Most banks seek a balanced approach that allows them to achieve the multiple goals discussed above. As a result, an increasing number of banks are choosing a portfolio approach to long-term incentives, providing on average two components (e.g. stock options and time-based restricted stock or performance shares and time-based restricted stock).

For awards with performance vesting criteria, incentive measures should represent shareholder return or long-term value creation. Performance measures can be based on absolute results, relative comparisons to other banks or both. Absolute goals should align with a bank’s strategic plan. Relative measures avoid the challenge of multi-year internal goal setting, but require the selection of an appropriate comparative group of banks.

Conclusion

Given the significance of incentive plans, it is important to begin discussions about the design of programs well in advance of the new performance year. Banks should ensure that their programs support strategic objectives, motivate participants to drive the success of the bank and align pay outcomes with performance results. Annual evaluation of prior year results can also ensure plans are effective and provide input for realigning the plans if appropriate.