Risk Versus Reward: Gauging Directors Pay

As a growing number of directors wrestle with the question of whether the rewards one receives for serving on a bank board outweigh or, at least, counterbalance a significant portion of the job’s inherent risk, the need for a simple yet definitive litmus test is becoming increasingly evident. While it may never be as clear-cut as, say, “heads I stay, tails I leave,” a review of peer information may help determine some industry benchmarks.

For its third annual survey of board compensation practices nationwide, Bank Director teamed up with Minneapolis-based Bank Compensation Strategies Group to gather credible, statistically valid comparative data. In doing so, we surveyed a diverse cross-section of directors representing a full range of bank asset sizes, from small community banks to large national players. We mailed 4,500 questionnaires and received responses from nearly 25% of our survey populationu00e2u20ac”totaling 1,064 participants. In addition to requesting profile data, annual compensation figures, and benefits information, we tested the waters on such issues as director impartiality and performance-based pay. We also allowed respondents to share their inner thoughts confidentially on any compensation-related topic.

One of the themes we heard loud and clear is that tying directors compensation to bank performance seems to make a lot of sense. Forty-seven percent of those we polled believe tying compensation to bank performance would have a positive influence on company performance. Another 48% were neutral, and only 5% indicated it could have a negative influence. And despite some of the arguments against such programs, a clear majority of our survey group (60%) does not believe performance-based pay has the potential to impede impartiality.

Likewise, survey comments overwhelmingly favored director compensation based on bank performance. “Directors should be compensated with stock options and benefits packages that are geared to performance,” one director stated. “Fees are not totally satisfactory and fail to recognize full involvement.” Another commented, “Compensation should reflect what has been achieved for our shareholders (after all, we are supposed to represent their interests).” Another agreed, writing, “Directors should think like shareholders. The director’s fees should be partially or totally in stock, and incentives for bank performance should be given to directors. They should set the direction for the bank and [receive] performance pay.”

Rich Chapman, president of Bank Compensation Strategies Group, says his recent experience confirms a rise in popularity of performance-based pay. “A number of things are happening. First of all, we’re seeing thrifts demutualize and becoming stock-based, so they’re talking about shareholder value more.” Also, he says, the performance standards that for years have been discussed at the larger institutions now have become common lingo at the community bank level. “Directors are getting smarter; [they’re] talking about shareholder value and performance benchmarks, and they’re reading about it in the newspaper. The whole idea is just more commonplace in the community and in the banking industry now than it was a few years ago.

“At the same time,” he continues, “shareholders are holding [community] bank managers accountable to the same performance measures as their larger bank counterparts: shareholder value, growth, alternative revenue sources (such as noninterest income), sales culture, market share. Now the CEOs and directors of these banks are saying, ‘Well, if we’ve got the same performance standards as the larger institutions, if our shareholders are expecting that of us, then we should have compensation that reflects that responsibility.’ It just naturally follows that performance-based comp is more in vogue today and certainly more appropriate.”

About 25% of our survey respondents, however, expressed concern over director impartiality and the potential for favoring short-term performance over long-term goals. “Tying compensation to bank performance can help if directors know they need to improve bank performance,” one said. “However, it can hurt if directors [make] short-term decisions to improve the bottom line on stock price rather than make a good, long-term decision that might hurt the bottom line and stock price in the short term.”

Another director was more skeptical, stating, “I have been on a bank board for 18 years. Compensation tied to performance has been manipulated and abused by people I’ve seen.”

But Chapman thinks that’s more talk than reality. He points out that while a management team or board can play around with the balance sheet and maybe rev up earnings for a year or two, ultimately that mentality comes home to roost. Because of regulatory controls and other factors, “banks are very process-oriented in their decision making,” he notes. “Maybe one director in 10 or one in 20 would actually try to run up the earnings of the bank to get a performance award, but it’s just not the nature of the industry.”

Besides, he argues, using a rolling-average measure can eliminate that concern. For example, Chapman says, the financial measurement for performance could be a three-year rolling average ROA. “That takes away any temptation to run up the earnings of the bank in the short term.”

So why aren’t more banks jumping on the performance-based pay bandwagon? Our survey results show less than 10% of banks currently offer performance-based incentives such as those tied to ROA, ROE, or stock price, to directors. Although Chapman expects that percentage to increase dramatically, he points to three mitigating factors: fear of regulatory scrutiny, lack of information, and the assumed link between performance-based pay and stock awards.

First, he says, “Directors are still afraid of overpaying themselves.” Although most everyone admits director compensation is artificially low, from the director’s viewpoint, there’s still lingering fear of regulatory reprisal for compensation deemed excessive. Second, is education. Although more is being done to disseminate peer information, most directors are still behind the learning curve as it relates to benefits and compensation.

Finally, there’s the natural assumption that performance-based pay should be tied to stock awards. The trouble is, according to Chapman, approximately two-thirds of all community banks are either closely held or widely held but thinly traded. Without actively traded stocks on which to base these awards, boards often require help to institute a performance-based compensation package that fits their particular needs.

Chapman offers one such suggestion: If your bank is closely held, set up a plan where the award is based on a percentage of salary. For example, if the directors receive a base fee of $400 a month, the bank could match that amount at the end of the year, based on meeting or surpassing performance benchmarks. “It’s a simple plan,” he says, “but it works.” Taking it one step further, he elaborates, rather than a cash matching program, the bank could defer the award and allow it to appreciate in value as if it were stock, in effect creating a phantom stock plan.

“My job,” Chapman says, “is to go into banks and implement plans that the boards and the compensation committees like. And the path of least resistance today is pay for performance. It’s clearly a win-win situation.”

Directors pay: how it stacks up

This year’s survey was broken out by asset size for five categories using the current sample. When looking at total compensation levels, it comes as no surprise that directors of larger institutions are paid higher, overall, than those from smaller or medium-sized asset ranges. Responses to other questions posed to directors, however, such as the number of directors whose banks have set up a performance-based pay program, were surprisingly consistent across all asset groups.

Figure 1 shows the results of the total average cash compensation levels broken out by asset category. Between the smallest and the largest of these groups, we can see a nearly fourfold difference in cash compensation, with directors of community banks of less than $100 million averaging $6,245 and those of institutions with more than $5 billion drawing an average of $22,154. Directors pay at banks from the middle asset group, $251 million-$1 billion, fell just between the two extremes, posting an average total cash compensation of $12,110.

A view of compensation levels geographically is less revealing. The states comprising the West region and those in the Northeast generally reported higher compensation amounts, regardless of asset size, than directors in the Midwest and South regions. Considering the geographic concentration of power among the nation’s largest institutions, especially within the last year or two, this picture makes sense. Average total compensation by geographic region is shown in Figure 2. These regional figures are broken further by asset size in Figure 3.

More realistic peer comparisons are likely to be found in the breakout of types of cash compensation by size of institution, regardless of the regional location of the bank. Figure 4 demonstrates a fairly large differential between large and small institutions in the average annual retainer reported by respondents. Directors of banks with less than $100 million reported an average annual retainer of $4,775; those from banks of $5 billion or more averaged $13,639u00e2u20ac”or nearly three times the smaller bank average. The average annual retainer for all directors responding was $8,012.

A less-dramatic difference is evident in the average board meeting fees offered by different-sized banks. When it comes to paying for committee service, however, the survey shows more of a contrast between large and small banks. Directors responding from banks of the smallest asset category averaged only $151 per committee meeting; those from the over $5 billion group averaged $419 per meeting. The average across all groups was $290 per committee meeting. Interestingly, the data from our survey show that, on the whole, directors are paid approximately half as much for their time on committee meetings as they are for full board meetings. This point is of interest because several directors commented that committee work is especially taxing and time consuming. “We are undercompensated for committee work and especially [for] the loan committee,” wrote one, “as it takes about six hours total for each meeting, including preparation.”

Regarding the issue of payment for board service, some directors aren’t so fortunate. Out of our survey group of 1,037 who responded to the question on annual retainers, 62% reported that they did not receive an annual retainer; nearly 13% told us they do not receive board meeting fees; and 33% said their banks pay no committee fees.

Not surprisingly, well over 100 comments on the survey were directed toward the issue of the amount of compensation directors consider to be fair. Overwhelmingly, directors we polled believe they are not given adequate remuneration for the risk involved with the job. “Directors are probably not compensated well enough to offset potential liability. They spend much more time than they are paid for,” wrote one. And while some directors surveyed find their compensation fair enough for the amount of time they spend on board business, nearly everyone agrees the amount of payment doesn’t begin to cover the risk and liability they incur.

“For the time and risk that a director faces, the compensation is a pittance. I believe that compensation will be increasing in the future if banks want to attract quality directors. The obligation and risk is a ‘real issue’ for current directors,” wrote one respondent.

Others admitted that there really is no amount that is sufficient to cover the risks or the scope of the job. “If a director does what he is supposed to do, he is not paid enough,” wrote one. Another echoed, “Considering the potential liability, I’m not sure you can pay directors enough. At times I think I’m absolutely crazy to be a bank director.”

While the above statistics refer only to cash compensation, a small proportion of the group noted that they were awarded stock last year as well. Out of the total survey population, 21% receive stock options; 6% received stock grants; and 2% have a phantom stock plan. Nevertheless, the popular appeal of such plans was evident in the comments, as directors overwhelmingly expressed the opinion that stock options are a great incentive to improve bank performance.

The little extras

While compensation is obviously the most important form of remuneration, some banks do offer general and retirement benefits to their directors. The vast majority of directors surveyed, however, reported that they do not receive benefits as part of their compensation package. Figure 5 outlines the percentages of those questioned that receive certain types of benefits.

Under the heading of general benefits, the pickings were somewhat slim. Travel expenses are offered to 39% of directors we polled and life insurance and medical insurance are offered to 14% of respondents. A handful of directors receive disability insurance and cancer insurance.

Forty-one percent of directors surveyed reported their institution offers some type of deferred compensation plan as a form of retirement benefit; only 8% said their institution offers directors a more traditional pension plan. About 2% mentioned a director emeritus fee as a type of retirement benefit.

Based upon the comments we received regarding benefits, many directors believe that these little extras help show appreciation for the work put in by the board. In some cases, benefits were viewed as an even better form of reward than cash. “Medical insurance would be a welcome additional benefit and could be in lieu of some compensation,” wrote one. “Health insurance would be great!” stated another. And when the bank itself has such plans in place, noted one director, “I think directors should be allowed to participate in the bank’s medical and retirement plans, the same as other employees.” Several board members expressed the view that the bank ought to provide a means of retirement for older directors with a reasonable monetary benefit based on years of serviceu00e2u20ac”particularly when age is a requirement for resigning from the board. “A pension plan or a deferred compensation plan would be a definite asset,” said one respondent.

Large to small

In the banking industry, there is perhaps no better delineator of the differences in bank culture than that of size. The fact that a $25 million asset institution whose main business is offering interest

on deposits and small business loans and a $400 billion financial

conglomerate with multinational ties are both part and parcel of the same industry is, at times, baffling. In light of this, we undertook to pull out some of the interesting trends we noted from respondents of small and large institutions.

It appears that directors of both large and small banks work just as hard on the job. About half of respondents across all sizes answered that they generally attend 13-20 meetings per year; the other half responded that they attend more than 20 meetings in 1997. That said, it makes the discrepancy in pay between large and small boards more poignant.

Directors were queried as to whether their board chairman is an outside director or an inside officer. The majority (66%) of small-bank directors reported that their chairmen are outsiders; only 17% of larger bank directors reported having an outside chairman. In some cases, respondents were adamant about this issue. “No inside director should ever be chairman of the board,” wrote one, and “…one inside director is enoughu00e2u20ac”inside directors resent outside directors, and board chairman should not be an inside director,” commented another. The reason, clearly, is the fear of an inside chairman having too much control over the decision-making process along with a lack of objectivity. “Pay levels should only be tied to profits if inside directors do not control the board or have outside directors who are cronies,” suggested one board member.

Closely related to the issue of having an inside versus outside chairman is the question of whether the bank pays additional fees to its inside directors for service on the board. Interestingly, although smaller bank directors outweighed those from larger banks in their sentiment against having inside chairmen, small banks greatly outnumbered large banks in the percentage that offer additional pay to inside officers who sit on the board. Sixty-one percent of small banks reported that they pay such fees, while only 14% of large institutions follow the practice.

It should be noted that our large bank data come primarly from banks $1B-$5B; outside chairman are even more rare at larger institutions, as borne out by a recent compensation study by William M. Mercer, Inc. Figure 6 reflects Mercer’s research on compensation and benefits at the nation’s largest banks.

Conclusion: risk versus reward

Where does all this lead us? What conclusion can we draw about the fairness of bank director pay levels in comparison to the heady responsibilities of the job? Most directors agree they are underpaid for the amount of responsibility and risk they assume under the director’s mantle. But still, they serve. And they do so because, as one director put it, “Pay should not be the primary motive to serve as a director.” Many noted that they are proud to be a director. And still others believe that to ask for more pay sends a message of greed, to both shareholders and the public.

Nonetheless, the gut-wrenching issue of liability remains close to the surface of any discussion regarding directors pay. One director said it best: “Considering the liability in the litigious climate of our society, it is a wonder you get any directors. Compensation guidelines don’t begin to justify the exposure.”

One of the ways to mitigate exposure from shareholders and regulators, thus, is by turning in excellent performance. So it’s no wonder that the majority of director’s opinions return time and time again to the advantages of performance-based pay. With all the public sentiment in its favor, will we see more of these plans in place by the time we poll directors in 1999? Rich Chapman believes there’s a good chance.

“A shocking number of bank directors think performance-based compensation is [their] dividends. They’re stockholders, therefore, if the bank does well, it pays a dividend. Well, then, they must love the IRS, because that dividend is double-taxed.

“Why aren’t they paying themselves by doubling their director fee if the bank performs? Then they’ve helped the shareholders and they’ve helped themselves. It’s old thinking. That’s why education is very important.”

Note: Bank Director would like to thank Bank Compensation Strategies Group as well as all directors who participated in this year’s survey and made this research possible.