Trends in Incentive Compensation: Risk and Deferrals

7-9-14-BCC.pngAs a result of the upheaval in the financial industry dating back to 2007, and as with most of the subsequent legislation, the community bank market has taken the brunt of the unintended consequences. This is no different in the area of compensation. The federal government has promulgated a flood of laws, regulation, and rules relating to the delivery of compensation within companies, but more directly within financial institutions.

Incentive Compensation
While compensation practices and payments have always had to fall within safe and sound banking practices, incentives, improperly structured, brought on problems. Some banks learned during the mid-1990s that incentive compensation structured solely to promote growth, particularly growth in the loan portfolio, was dangerous. That was especially true if the bank made the incentive payment immediately, or shortly after year-end. 

As a result, for a time after the mid-1990s, many banks were reluctant to delve into incentive compensation. As we have worked with banks since that time, more and more have been open to implementing annual incentives and deferred incentives so long as the structure implemented was flexible so that the incentives can/will be changed to address the current needs of the bank; addressed short-term, intermediate term and long-term risk associated with the incentive; and was compliant from a regulatory standpoint.

So that a bank has an incentive structure that provides flexibility, it is paramount to emphasize with the participants that the incentive program should not be expected year after year, and may change annually. Also, at implementation as well as each year thereafter, the participant should understand that the incentives absolutely will change based upon the environment the bank is operating in and the current needs of the bank. Goals can be bank-wide, branch-wide, individually based, or any combination of all three.

Risk with incentives has really been a hot topic with the regulators over the last six to seven years, beginning with the Troubled Asset Relief Program (TARP), when everything from bonuses to stock options were prohibited so long as TARP funds had not been repaid. Generally, the Interagency Guidance on Sound Incentive Compensation Policies, promulgated in June, 2010, set forth the expectation that some incentive compensation be at risk to the participant. Included in the guidance was the recommendation that for large banking organizations, some of the incentive should be subject to deferral. Deferrals have become a more common practice among community banks as well. Even without the new regulations, it seems more banks are looking to deferrals for the purpose of retention, as pay for performance has become a more significant component of the compensation packages of key hires.

Deferred Compensation
While deferred compensation for key personnel has existed for decades now, how that deferred compensation is being structured has evolved. Since the financial crisis, many banks are looking to other alternatives when it comes time to include the next generation of executives into some sort of deferred compensation program. In addition to using Supplemental Executive Retirement Plans (SERPs) or Salary Continuation Plans (SCPs), some banks are exploring using defined contribution structures. The reason for this is simple. With a defined benefit program, the bank is required to make liability accruals every year to the balance sheet for the SERP or SCP, which has with it a corresponding expense. Since the banking industry has recently gone through a period of struggle, being required to make deferred compensation accruals in a year where the bank may not be performing has been difficult. Therefore, by having a program that defines the contribution, the bank can have better control of determining when an accrual to the deferred compensation program occurs.

Many of our clients have asked us to design incentive compensation plans using Bank Owned Life Insurance (BOLI) to assist in offsetting the expense tied to the plans. This allows the compensation packages to be significant in value to the key employees, yet less significant in cost to the shareholders.

While there is more regulation to comply with following the financial crisis, if structured properly, banks can still implement creative and customized compensation programs unique to their institution to retain, recruit and reward key employees.