Director Pay Puzzle

For the second year in a row, Bank Director’s 2013 Compensation Survey reveals that directors and CEOs at the nation’s banks still struggle with the age-old question: How do we pay top executives in a way that rewards them fairly, yet keeps regulators and shareholders happy?

Sixty-nine percent of the more than 300 directors and executives that completed the compensation survey indicate that tying compensation to performance remains a top challenge for their institutions. The survey was conducted in March of this year and sponsored by Jenkintown, Pennsylvania-based consulting firm Compensation Advisors by Meyer-Chatfield. Whether publicly traded or privately held, big or small, East Coast or West Coast, banks across the country continue to struggle with this issue.

Bank boards face a seemingly complex puzzle when it comes to gauging performance, particularly in determining what performance criteria to measure, and what amount and form of pay is appropriate. Busy directors deal with many issues in a limited amount of time, “so pay for performance continues to be a struggle, because it’s such a large issue that has so many moving and variable components that [boards] really don’t know how to get a handle on it,” says Flynt Gallagher, president of Compensation Advisors by Meyer-Chatfield.

Forty percent of respondents also reveal concerns about talent retention and, perhaps not surprisingly, 41 percent find that understanding and complying with regulations continues to be a challenge. Not much has changed in a year: These three challenges are the same three that directors and executives grappled with in 2012.

Retaining top talent at the executive level is vital in a heavily regulated industry still undergoing intense scrutiny in the aftermath of the financial crisis. Forty-four percent of respondents report that an executive or critical employee had left their institution within the last three years. Executive departures are most prevalent among the largest banks, with more than $5 billion in assets, and the smallest banks, with less than $100 million in assets. Respondents from the largest banks, which receive the lions’ share of scrutiny from shareholders and regulators, report the most terminations. However, the smallest banks struggle with this issue most, reporting the most executive departures, at 56 percent.

Silver Lining in Departures
Richard Morin Sr., a member of the board at Colonial Co-Operative Bank, a $70-million asset institution based in Gardner, Massachusetts, which is struggling under the weight of a Federal Deposit Insurance Corp. consent order, sees a silver lining to executive departures. New management is taking the bank in a new direction. “What happened to us was really a blessing in a way,” he says. The bank lost highly-paid, yet highly specialized, senior executives, allowing the board to promote internal candidates with more varied skill sets up to the executive level. “We’re trying to become more efficient, groom the right people, recruit the right people, but it takes time to turn the ship around,” he says.

While Morin found a silver lining from executive departures, the industry as a whole suffers from a talent drain. Executive training programs at large institutions, which produced many community bank executives in the past, aren’t as prevalent anymore. The departures of retiring baby boomer executives, coupled with younger talent exiting the industry due to media scrutiny and regulatory pressures, leaves banks with a talent gap that could prove difficult to fill. “Being able to promote from within is becoming more and more difficult, because retention is becoming a big issue,” says Gallagher. “There’s no formal training program or mentoring program to prepare the next generation of executives.”

Managing Executive Pay
Amid concerns about talent retention, it’s vital that bank boards find a solution to the compensation puzzle. Respondents to the 2013 survey seem to feel that they are getting closer to achieving the right mix for executive pay. The mood has lightened a bit since last year, when just 59 percent felt that the bank’s executive compensation program was managed well or very well. This year, more respondents think their board is managing executive compensation programs well or very well, an increase of 15 percentage points to 74 percent.

Respondents show an increased likelihood to tie CEO compensation with a strategic plan or similar set of goals. Those indicating that their banks tie compensation to corporate goals rose by 12 percentage points from 2012. Only one-third say the bank does not tie CEO compensation to any strategic goals. Premier Valley Bank, a $549-million asset bank based in Fresno, California, enjoyed a profitable year in 2012; in fact, the year was the most profitable in the bank’s history. So how did solid performance for the year trickle down in the form of executive pay? J. Mike McGowan, president and CEO of the bank, says the board’s compensation committee aligns executive compensation to shareholder interests through the use of performance indicators. “We’ve made a leap of faith and a concerted effort to connect pay for performance to shareholder interests,” he says.

Seventy-one percent of respondents indicate that they link CEO compensation to performance indicators, with return on assets and asset quality, both at 44 percent, chosen as the most common performance indicators used. Institutions with assets of more than $1 billion are significantly more likely to link executive compensation to a strategic plan or performance indicators.

Executives: Show Me the Money
In an economy where earnings are dicey and the outlook not as rosy as it was before the financial crisis, 85 percent of respondents indicate that salary in the form of cash is what executives value most. Only 2 percent say it has little or no value. Bank Director asked respondents to rate what they believe executives value as a part of the executive compensation package, using a scale of 1 to 5. A rating of a 4 or 5 indicates valued or most valued, while a 1 or 2 indicates no or little value. Seventy-three percent of respondents value annual incentives, also a form of compensation commonly earned as cash, as part of an executive pay package. Equity lost value after the financial crisis, and the Troubled Asset Relief Program (TARP) placed restrictions on certain kinds of equity incentives, so “cash was really about the only vehicle that was still available,” says Gallagher.

Only 45 percent of respondents say executives value equity, but the perceived value of equity compensation rises as the size of the bank increases, with 89 percent of respondents from the largest banks indicating that they value providing equity compensation for their executives.

Thirty-eight percent indicate that non-qualified deferred compensation plans, which promise to pay executives a defined benefit or contribution at a future date, hold little value in today’s executive compensation package, and 60 percent indicate that their banks do not offer this benefit. For banks concerned with talent retention in the executive ranks, this could be a missed opportunity, as deferred compensation plans are customizable to individual executives and can be a strong-and relatively inexpensive-retention tool, says Gallagher.

Fair Pay for Directors
Executives are not alone in their desire for cash compensation. When asked what compensation is valued as a member of the board, 80 percent of respondents select cash fees and/or retainers as being valuable or most valuable. Least valued are insurance and retirement plans, with just 14 percent of respondents assigning a high value to these benefits.

Directors know what they want in their compensation mix, but with the increased responsibility placed on bank boards today, do board members feel that they are fairly compensated for the amount of time and responsibility devoted to their banks? Sixty-two percent of respondents believe so. However, board members at the smallest and largest banks are the least satisfied with compensation for the amount of work they do. Boards of the biggest banks are very aware of the scrutiny they face from shareholders, investment analysts, shareholder advisory groups and the public, so “the directors realize that no amount of compensation is going to adequately reward them for the liability they’re assuming,” says Gallagher. The smallest banks lack the resources to compensate boards appropriately, so these directors often “have to work a lot for little pay,” he adds.

Of the survey’s respondents, only 7 percent indicate that director pay is tied to performance indicators like earnings per share growth, asset quality and return on assets. Despite this, there is no agreement among the respondents on whether the use of performance indicators in director compensation is in conflict with the board’s fiduciary responsibilities. Lee Delp, chairman of the compensation committee at Univest Corp. of Pennsylvania, a $2.3-billion asset holding company headquartered in Souderton, Pennsylvania, counts himself as one board member who doesn’t see a conflict in performance-based pay for boards. “What I think is a problem is. . . incenting for short-term results. That I’m totally against,” he says. “We have a [bank] culture where that just plain doesn’t happen.”

According to Gallagher, it all boils down to bank performance versus board performance. Tying director pay to the bank’s performance could present a conflict of interest for the board. “A director’s responsibility is to make decisions in the best interest of the shareholder,” he says. “Sometimes they have to make tough decisions that impact short-term performance negatively.” However, if pay is based upon board performance, including the director’s time, expertise and contributions in meetings, “now we’re talking about how well does a director discharge his responsibilities and how well is he prepared.” Boards can also examine what type of pay is tied to performance. While cash compensation may be the pay of choice for directors, compensation with long-term benefits, like equity, may be key to keeping director performance in line with shareholder interests.

Director Compensation Mix
Will equity compensation come roaring back in the next few years? Twenty-nine percent of survey respondents report that director pay currently includes equity compensation, compared to 83 percent that report receipt of board meeting fees and 49 percent that receive an annual cash retainer. As the economy improves, equity pay may rise again to take a key place in the compensation mix. McGowan at Premier Valley Bank would like to see equity pay make a comeback, as he feels that equity compensation better aligns director performance with shareholder interests. “Why would the shareholders not be better off with their interests aligned with the directors’ interest?” says McGowan. Premier Valley Bank started out with equity as the sole form of compensation for directors and organizers, and the majority of compensation for executives, after the bank’s founding in June of 2001. Equity pay at the bank, which comprises about one-third of total compensation, is still a greater part of the compensation mix than what McGowan sees at peer institutions, but cash compensation has risen in importance due to industry trends. Gallagher thinks that other forms of compensation, including equity, will become larger pieces in the compensation puzzle as the market stabilizes.

Benefit plans, which Gallagher says received a bad rap after the financial crisis, continue to decline in importance. When asked about overall benefits for outside directors, including travel expenses, life insurance and retirement plans, 58 percent report that their institutions offer no benefits at all, representing a continued erosion of benefits since 2010, when 72 percent of respondents reported that outside directors receive benefits. Thirty-one percent this year report that their directors receive travel expenses, the most popular form of benefit. Banks with more than $1 billion in assets report more of an inclination to offer benefits, with 62 percent offering some sort of benefit, mostly in the form of travel expenses and deferred compensation. Respondents reporting benefits offered for board service fall along with the size of the bank, with 17 percent of respondents from the smallest banks, with less than $100 million in assets, reporting that the only benefit they receive comes in the form of travel expenses, while 83 percent see no additional benefits at all.

According to Gallagher, the decline in benefits reported by directors isn’t a surprise. Cost is a key factor in the reduction of benefits like pension plans, and the expectations of board members have shifted. Many benefit plans suited for younger employees aren’t a good fit for older directors, and younger directors newly elected to the board, seeing benefits decline at their own companies, don’t expect expensive benefits like pension plans. “They’re used to providing their own retirement benefits,” he says.

Board Pay and Time Hold Steady
As banks continue their long climb out of the crisis, will bank boards see an increase in director pay? Most respondents, at 63 percent, expect compensation to stay level in 2014, while 35 percent expect a pay raise. Only 2 percent expect to see compensation decline. Respondents from banks in the South express a bit more pessimism regarding director pay, with just 31 percent expecting an increase while 50 percent of respondents from banks in the West expect an increase. Banks in the South, still dealing with non-performing loans and assets, have taken longer to recover than the rest of the country. “Until they have righted the ship,” says Gallagher, “I don’t see pay increasing significantly. I think they’re still struggling” to survive.

The time respondents report spending monthly on board activities, including meetings, training and business development, remains steady this year at a median of 15 hours per month. Something directors report spending the least amount of time on is compensation. When asked about where boards focus their time and energy, only 9 percent indicate that compensation took most of their time. With satisfaction in compensation programs for directors and executives continuing to rise, and many uncertainties about compensation risk settled, it makes sense that boards would move on to the next topic on the horizon. However, “as we see continued [executive] turnover,” says Gallagher, “we’re going to see compensation take the forefront again.”

Overall, respondents say boards are spending the most time on lending and regulatory issues, both at 60 percent, and risk issues, at 58 percent. Respondents from larger, publicly-traded banks have a stronger focus on risk, while smaller, privately-held banks focus on lending. The significant amount of time spent by boards on regulatory issues doesn’t surprise many in the industry. Regulations and guidance coming out of Washington are going to be a focal point for boards and executives over the next five years, says Gallagher. “It’s going to take that long for people to understand what’s embedded in the body of all these directives.”

Strangely, the smallest institutions spend the most time on regulatory issues, despite the fact that many of the rules apply to the largest institutions. Smaller institutions are not any more troubled by enforcement actions than larger ones. Data reported by SNL Financial shows that 10 percent of banks with less than $100 million in assets were under a severe enforcement action, such as a cease and desist order, as of May, slightly below the industry average of 12 percent. However, regulations can tax the resources and staff of smaller institutions further than their larger brethren.

So why do directors do what they do? Why take on the liability and responsibilities of serving on a bank board post-crisis? For most bank directors, it’s really not about the pay. “If you’re doing it for compensation, you’re doing it for the wrong reason,” says Delp. “I do it because I believe in a community bank.” Morin agrees. “Big banks don’t have the stake in the small communities that the community banks do,” he says. “I want to be a part of the fight to keep [community banks].”

So would they do it for free? Morin has received no director compensation while his bank works to emerge from the consent order, and loves his role as a community bank director. However, he feels that if banks want to attract quality board members, fair compensation should be offered. Besides, he says, “it certainly makes it more fun when you get paid.”

About the survey respondents
In March, over 300 directors and senior executives of financial institutions across the United States responded to the 2013 Compensation Survey, conducted via email by Bank Director. Outside directors were 49 percent of the respondents. Of the respondents, 12 percent were from banks with $5 billion or more in assets, 17 percent from banks between $1 billion and $5 billion in assets, 20 percent from banks between $500 million and $1 billion in assets, 22 percent between $250 million and $500 million in assets, 21 percent between $100 million and $250 million in assets and 9 percent from banks below $100 million in assets. Those surveyed represented an almost even distribution between publicly traded and privately held institutions, with 45 percent from public banks and 47 percent from private. The largest number of respondents came from banks in the Midwest, at 39 percent, with just 15 percent of respondents identifying that their bank is located in the West. Twenty-five percent of respondents were from banks in the South, with 21 percent from the Northeast. Full summary results of the survey are available in the research section at BankDirector.com.