Attracting and retaining the most talented senior executives are key responsibilities of the bank board. But how do you do that, especially in an age where compensation programs are changing and there is more pressure on bank boards to design compensation programs that reward performance?
For key employees, one of the more popular ways to provide wealth accumulation opportunities is through a nonqualified deferred compensation plan, more specifically a Supplemental Executive Retirement Plan or SERP. Traditionally, SERPs have been defined benefit (DB) plans, where the bank promises to pay a fixed dollar amount (e.g., $50,000 per year) or a percentage of compensation (e.g., 25 percent of final average salary) during retirement. Defined benefit SERPs offer the highest attraction and reward value, and are often used to address the disparity between key and rank-and-file employees. (Typically, rank-and-file employees have a greater percentage of their income replaced in retirement than executives using traditional retirement plans.)
Accounting rules dictate how the bank should expense and accrue for the benefit. If the participant remains employed by the bank until retirement, the benefit will be paid. Defined benefit SERPs are not tied directly to bank performance, and this has led to some criticism and resistance to implementing them.
As a result, performance-based SERPs are increasingly being considered. With a performance-based SERP, an annual award is based on attainment of pre-defined goals. In other words, it’s a defined contribution or DC SERP. Since participants are usually senior executives, the DC SERP goals are typically bank-wide instead of individualized goals. They can be the same goals used for determining short-term incentives; in fact, there is administrative ease in such goal consistency. Unlike the annual incentive that is paid out now, however, each DC SERP award is deferred until retirement. Over the life of the plan, the awards accumulate and are distributed at retirement.
From an accounting perspective, DC SERP modeling is more complicated than DB SERP modeling but is built on the same principles. Under a DC SERP, if a 50-year old participant receives an award of $50,000 to be paid in installments beginning at age 65, GAAP (Generally Accepted Accounting Principles) requires the bank to expense the award at its net present value, and thereafter increase the balance sheet amount each year until retirement. Subsequent awards go through the same process—picture stacking Legos.
Boards should recognize that DC SERPs can result in greater benefits to the participants than a DB SERP. When properly designed, if a high-performing bank continuously achieves its goals, the cumulative DC SERP awards should be greater. It may also be desirable to have both a DB SERP and a DC SERP.
The normal expected retirement benefit is where most of the focus is, as that is what drives everyday accounting. However, proper SERP design requires consideration of other events that trigger distribution. The question for each trigger is what—if any—benefit should be paid.
- Early voluntary termination. This is when the participant leaves employment before normal retirement age. Often there is no benefit, or there are several years of participation before any benefit begins to vest.
- Early involuntary termination. Here, the participant is terminated by the bank without cause, or for defined “good reasons.” Often, there is some vesting immediately, whether in just the accrued benefit or some accelerated amount.
- Disability. The participant suffers illness or injury that results in termination or meets the definition of Disability in IRC Section 409A. Typically, there is 100 percent immediate vesting in either the accrued benefit or some accelerated amount.
- Change in control. When an acquisition takes place, the transaction is usually one trigger, and the participant’s termination of employment is a second trigger. Should one or both triggers be required for a payout to occur? Should the second trigger be voluntary or involuntary? Typically, there is some vesting immediately, but the amounts can vary significantly. Change in control benefits should be carefully considered, as there are Internal Revenue Code provisions that could tax these benefits heavily and impact a company’s ability to deduct them.
- Death. Should the accrued benefit be paid, or some higher amount?
The board should understand the potential maximum payout and the impact on the bank’s income statement and balance sheet for each trigger, especially those that accelerate the amount compared to what has been accrued. Disability and death events can be insured; others cannot.
SERP design is both art and science. While the science is the same for all, working with an experienced vendor will make the art reflect your bank’s objectives.