A Balanced Approach

Scenario: For CEO Ed Davis, it’s not just another day at the bank. In 20 minutes he meets with his chairman of the compensation committee to set the agenda for the next meeting. Once again, the challenge is how to have a meaningful discussion about implementing a supplemental pension program for himself and two senior officers whose retirement benefits are penalized by regulatory limitations.

The last time this topic came up was when new employment contracts were approved, and the directors declined to deal with both issues at the same time. It’s common knowledge that several directors feel that the stock option package is reward enough for the CEO, but Davis sees his pension and options as two separate issues. The bank and shareholders have done very well during his 12-year tenure. CEO Davis has peer and consultant data to support the pension reconsideration, but he’s still concerned about how self-serving it appears. He wonders how other CEOs and boards have dealt with this issue.

“Executives today need flexibility in putting together a financial plan to best suit their needs to provide for current family needs and future retirement needs. The stage of life a person is in determines the appeal of one need over the other.

At HF Financial Corp., executive base salary is determined by peer group comparison. Incentive pay is based on meeting or exceeding predetermined financial objectives. We use incentive pay as the wealth-building component. Cash is used for short-term incentive pay and stock options are used for long-term incentive pay. Pension objectives are met with employer contributions to a defined benefit pension plan and Employee Stock Ownership Plan (ESOP). The total contribution made to these two plans is targeted to not exceed a certain percentage of total compensation. In addition two choices are provided for employee and executive self-funding: a 401(k) plan and, for executives, a deferred compensation plan.

These plans offer us a compensation package that is competitive and flexible. It gives us a recruiting and retention tool that allows us to attract and retain a strong management team at a cost that is controllable and affordable.”

Curtis Hage

Chief Executive Officer

Home Federal Savings Bank

Sioux Falls, South Dakota

“Securing a benefit for Davis and his officers will be no small challenge. Although the facts and statistics are stacked in his favor, he will likely be perceived as trying to feather his own nest. A well-defined strategy is the key, combined with patience and perseverance.

It’s a mistake to have the compensation committee take a recommendation to the board without first getting the board to agree that there is a problem that needs to be addressed. I agree with Davis that his pension benefits and his stock options need to be viewed as two separate parts of his total package. Stock options may prove to be an important equity builder, but options seldom fulfill retirement cash flow needs. Pension shortfalls require pension supplements, not stock options.

If Davis is running a widely held, thinly traded community bank, his battle will be tougher. In our experience, these types of banks do not yet fully embrace the need to reward the rainmakers in a manner that compares favorably with larger public banks. My recommendation is for Davis to 1) be sure of his facts (i.e., benefit shortfalls), 2) convince the board that the problem needs to be addressed, 3) create an advocate on the compensation committee, 4) tie his and his officers’ pension supplement to bank performance, and 5) persevere. It is worth going to the mat for this benefit. In the end, it is a win/winu00e2u20ac”management is rewarded for performance while shareholders benefit from increased stock value.”

Richard Chapman

President and CEO

Bank Compensation Strategies

Minneapolis, Minnesota

“Selecting and retaining the CEO is a bank board’s most important responsibility. It’s my experience that directors rely heavily on the expertise of the CEO, and a chief executive’s compensation package must be properly structured to reward the expectations of the board.

The board of this bank should not hesitate to turn down the supplemental pension request if it is paying a salary competitive with similar banks and has been fair in awarding options to its CEO. Placing the CEO in a position to be handsomely rewarded for meeting performance goals and enhancing the overall value of the bank is a key element in today’s compensation packages and a great way of aligning management with the interests of the shareholders.

Each bank has a unique board/CEO relationship and both sides must structure a compensation program that works best for their bank. The bottom line is that chief executives must be properly rewarded for doing a good job and the structure of that short and long-term incentive should be left up to the creative imagination of the CEO and the directors.”

Joe Julian

JJID Inc.

Wilmington, Delaware

“It is generally agreed that the one of the most important duties of the board is to hire a capable CEO to manage the company. Subsequently, the board should establish a compensation program that will retain the person they have selected. The compensation plan should be structured to motivate. It should also allow the senior staff to be comfortable with the knowledge that they are being adequately compensated in relationship to their peers, with above average compensation for good or exceptional performance.

CEO Davis should not be reluctant to bring these compensation issues to his board. If he doesn’t, who will present his case? He also has a responsibility to his senior officers. If CEO Davis has concerns about presenting legitimate compensation issues to his board, he may need to examine his relationship with the board. The ability to have forthright discussion about compensation issues at this level is important and is a board responsibility.”

Robert H. Pillers

Chairman

Effingham State Bank

Effingham, Illinois

“The situation described is not an uncommon one. It is very difficult for bank CEOs who are not in an ownership position to develop plans for their compensation unless they are negotiating at the front end of an employment contract prior to being hired. This particular CEO should probably concentrate with his board more on the pay levels of his two senior officers than on his own compensation.

It is assumed in this scenario that the bank has been performing well and that the two senior officers are top notch and have significantly contributed to the bank’s success. If that is the case and there is information available that supplemental pension plans are being made part of senior management compensation by peer group banks, then this bank should make similar compensation arrangements or risk losing the officers to competitors if their compensation packages are not updated.

At the very least, the CEO owes it to himself and his senior management to inform the board as to current compensation strategies in banking. It seems to me that there is a fiduciary obligation on the CEO to take this approach even though it might seem self-serving. Obviously, merely informing the board does not guarantee that they will make any significant changes.”

David R. Seim

President and CEO

Lubbock National Bank

Lubbock, Texas

“I wonder how long ago the options were approved. If it was recently, it’s possible that the CEO has not participated in the increased value to the same extent as the outside directors and other shareholders. I agree that the pension and options are separate issues. Pensions may be used to reward years of diligent service and options to reward outstanding financial performance that results in increased return to shareholders. The structure of the company, the demographics of the shareholder base, and the interests of large shareholders may affect net income, increased book value, and market price. These elements most likely are beyond the control of the CEO. My experience leads me to believe that the CEO is served best by bringing in a consultant familiar with packages offered to CEOs of comparable institutions and letting the consultant present the CEO’s case. Human nature being what it is, the outside directors may suspect that Davis’ efforts are self-serving, no matter how honorable his intentions.”

Mike Dickerson

Chief Executive Officer

National Bank of Sussex County

Branchville, New Jersey

“Since Mr. Davis has been at the helm for 12 years with seemingly much success, I would assume that he has developed a good working relationship with the board of directors. It also follows that he can communicate well with the board on a variety of issues and that his opinion is respected by them.

Directors have come to expect an analysis of compensation packages of competing firms when reviewing their own senior people in order to ensure that they retain good employees. Perhaps most critical to the board is retaining CEO Davis.

With these assumptions, Mr. Davis should not worry about being self-serving, for it is his responsibility to try to retain staff. Any discussion with the compensation committee or the board should include an objective comparison of compensation packages of competing firms. The review should detail the compensation items that are missing from his and the two senior officers’ pay packages. Mr. Davis should then make a reasonable, concise proposal detailing the increased costs involved.

In all likelihood, the board would rather compensate known champions of the company than to begin a search for a new CEO and two senior officers.”

Catherine A. Ghiglieri

Commissioner

Texas Department of Banking

Austin, Texas

“Mr. Davis should direct the committee’s attention to the bank’s overall structures for providing long-term incentives to directors as well as officers. This will enable him to avoid being submarined by controversy over whether his stock options act as a substitute for nonqualified pension accruals. It will also defuse the common perception that supplemental retirement plans (SERPs) are corporate giveaways that serve marginal business purposes.

Davis should start with the subject of deferred compensation. This topic is more than innocuous: it may benefitu00e2u20ac”and therefore personally interestu00e2u20ac”board members. If a plan already exists, there is always room for improvement (e.g., alternative rates of investment return, matching contributions, and rabbi trusts). If no plan exists, its merits could be discussed. Many directors are surprised by the personal tax benefits and minimal costs for such plans.

The dialogue should ultimately turn to the corporate purposes that could be advanced through annual bank credits that reflect financial performance. Their amount could target what would otherwise accrue under a SERP. Vesting could depend on safe future operations. A noncompetition agreement may have appeal, with benefits being forfeited upon its violation.

Frankly, Mr. Davis’s goal should be obtaining committee support for independent outside advice about alternatives that are worth considering. This strategy will subtly yet squarely move the focus from the CEO’s personal interests to an inclusive plan for advancing long-term board objectives. Who can argue with that? Therein lies the foundation for action that sells in the boardroom.”

J. Mark Poerio

Executive Compensation Attorney

Kutak Rock

Washington, D.C.