Banks Prepare for a Maze of New Rules on Incentive Pay

JPMorgan Chase & Co. made world headlines last spring over trading losses that eclipsed $5 billion, and then made headlines again when it went after back pay from the traders worth as much as two years of their annual compensation. Ouch.

Citigroup also made headlines of its own this year when it failed a say-on-pay advisory shareholder vote, which forced the board to promise to reconsider the $15 million pay package of Chief Executive Officer Vikram Pandit.

Ouch again.

Most of the nation’s banks will never get as much scrutiny from shareholders, the media and regulators as JPMorgan and Citigroup, but they are facing an entirely new world when it comes to incentive compensation.

This will mean fundamental changes to the way banks pay people. Clawback policies once were mostly limited to fraud and misrepresentation. Now they are getting expanded to actions that may cause reputational harm, as in the case of JPMorgan’s own clawback policy. Banks are facing advisory shareholder votes than can be embarrassing to say the least. Boards are incorporating risk managers into analysis of the compensation packages, in some cases for the first time, and analyzing the risks to the company inherent in everything from senior officers’ pay to commercial lenders. Short-term cash bonuses are getting deferred based on performance that plays out over two to three years.

“Boards aren’t used to paying people in this way,” says Marc Trevino, the managing partner in the executive compensation group at Sullivan & Cromwell in New York. “I don’t remember seeing a time when there was such a radical change in how this is done.”

Bank boards face a tsunami in new pay regulations, many of them borne out of the Dodd-Frank Act of 2010, that still haven’t come to shore and will fundamentally change pay structures. But they are coming. Regulators released proposed rules on everything from clawbacks for publicly traded companies, pay-for-performance rules and deferrals for big banks. The Federal Reserve is analyzing the pay structures at the nation’s biggest banks and many believe the results of that analysis will impact smaller banks as well. Shareholders have a greater say at publicly traded companies and are putting pressure on banks to change compensation policies. Even without knowing the full impact of these regulatory and shareholder interests, bank boards should start planning for these prospective changes now, because it can take a year of discussion just to iron out the details of a comprehensive pay plan.

“The big issue is the greater amount of attention to risk in compensation design,” says Rose Marie Orens, senior partner at Compensation Advisory Partners in New York. “That’s a huge change for the risk function. This is a big effort for banks to try to make that work. How do you get these different functions to all get involved and how do you capture the information you need and backtest the plans to see if you’re getting behavior consistent with what you want, yet still motivate people?”

The regulators want plans “to be dull,” she says. Shareholders, on the other hand, want people motivated to work hard and stretch themselves, not by violating ethical standards or putting the organization at risk, but to contribute in a major way.

“You want people to think they can have attractive compensation,” she says. “That is hard to balance.”

That balance is becoming harder in the wake of the financial crisis, which brought about a host of new rules to try to limit the potential harmful impact of the wrong sort of incentives. Bank regulators gave their view of the matter in 2010’s jointly issued “Guidance on Sound Incentive Compensation Policies,” which says that “flawed incentive compensation practices in the financial industry were one of the many factors contributing to the financial crisis that began in 2007,” and that shareholder interests’ aren’t necessarily aligned with the long-term interests of the company.

The guidance told bank boards they were responsible for the first time for reviewing the risk inherent in all incentive programs, including incentives for lower-level groups of employees such as lenders. For some of the larger banks, these are groups that encompass thousands of employees.

“Any mortgage person is a risk person, even if they don’t have anything to do with the underwriting program,” Owens says.

Senior risk management professionals are not only getting involved in making decisions about structuring pay, but they are helping to evaluate senior executives for bonuses based on their level of commitment to compliance and internal controls, which wasn’t part of their job in previous years, pay consultants say.

“Compliance and risk departments are much more involved in compensation than they ever were before,” says Wendy Hilburn, a principal at pay consulting firm Frederick W. Cook & Co. in New York.

Even though the regulatory guidance went into effect in 2010, not every bank is following it. In the accounting and consulting firm Crowe Horwath LLP’s 2012 compensation survey of 297 banks, only 60 percent said the board was involved in deciding the structure of incentive pay. The regulators don’t have a prescription for exactly how to structure incentive pay, and acknowledge that larger banks will have more resources and more complex risks to address.

Still, it has been a challenge for smaller banks to meet the joint regulators’ 2010 guidance, says Flynt Gallagher, the president of Meyer-Chatfield Compensation Advisors in Pensacola, Florida. Many small banks don’t have a chief risk officer to get involved in design of incentive compensation. They may give this responsibility to the chief financial officer or some other senior vice president, or no one at all. Gallagher says he still goes into banks and asks to speak to the person in charge of risk and is sometimes told, ‘We don’t know what you’re talking about.’”

That could be a problem.

“Examiners are using incentive compensation as part of the exam,” he says. “It could impact your CAMELS rating [regulatory strength score for banks].”

The regulators aren’t so much focused on the dollar amount of pay as they are on the risk inherent in that pay, and whether employees are being incentivized to take on risks that could hurt the bank later. Getting risk managers involved in the compensation discussion early is key, said Jim Nelson, a senior vice president at the Federal Reserve Bank of Chicago, speaking at a Bank Director conference last November.

“If [incentives are] completely discretionary with no guidance as to what the decision makers are going to be looking at, we find that problematic,” said Nelson.

Although regulators have so far shied away from specific numbers or one-size-fits-all rules that apply to small and big banks alike, the first thing to do is look at the size of incentives compared to overall pay, he said.

“If you have people in your organization who can triple their compensation if they meet certain goals, than they have a lot more incentive to hit those goals than someone who can increase their salary by 25 percent,” Nelson said.

Bank boards, on other hand, still worry that they’ll lose talent if they don’t provide an incentive to stay, or they somehow won’t be competitive.

“Our CEO could make more [money] going to a bigger bank and being an executive vice president and have less work to do and less responsibility and fewer rubber chicken dinners to go to,” says Tom Waring, the chairman of the compensation committee for Evans Bancorp, a publicly traded $733-million asset holding company in Hamburg, New York. “How would our shareholders feel if we lost him?”

Years ago, executives at the bank got a bonus every year no matter what they did. “It was very subjective,” Waring says. “In my experience, there wasn’t a time we didn’t pay it out. It became almost anticipated.”

But four years ago, in the midst of hard times, executives at the bank stopped getting bonuses. The board also took at fresh look at the bank’s incentive plan. It now has a short-term plan tied to several bank and individual performance measures that executives know they have to achieve to get a bonus. If the bank doesn’t meet several performance measures, no one gets a bonus. If the individual executive doesn’t meet 100 percent of his or her four or five personal goals, that person’s bonus is reduced.

Last year, the bank paid Chief Executive Officer David Nasca $268,665 in salary and a $81,000 bonus. The cost for a long-term equity and stock option plan was $38,000.

Finding out what shareholders think of the changes at Evans Bancorp will be a new experience for the company. Because it’s a smaller institution, Evans won’t be subject until 2013 to the new say-on-pay requirement from the Dodd-Frank Act that gives shareholders of publicly traded companies a nonbinding vote on executive pay.

The new rules shift weight to institutional shareholders, who often follow the lead of advisory groups such as Institutional Shareholder Services (ISS), says Susan O’Donnell, a managing partner at Pearl Meyer & Partners in Boston. These groups are leaning on companies to pay more incentives in so-called performance shares, which only vest if certain performance goals are achieved. These can be restricted stock or options with performance conditions attached to them.

O’Donnell says she has seen banks go from giving 20 to 30 percent of executive incentive pay in performance shares to 50 percent, in part because of the pressure to reduce short-term bonuses and shift incentive pay out to longer terms.

“[Companies] are all panicked about ISS,” she says. “I’ve told them they need to pay attention if they have institutional ownership at 50 percent or more.”

Shareholder votes also put more pressure on companies to pay executives based on stock performance. Shareholders hate it when an executive makes a lot of money while they lost money.

What’s coming from regulators may be more difficult to figure out. Banks above $1 billion in assets will have to comply with new rules for their incentive packages under the Dodd-Frank Act that closely mirror the gist of the 2010 guidance, but have not been finalized. As part of that proposal, banks above $50 billion in assets will have to start deferring at least 50 percent of executive incentive pay over a period of three years, but O’Donnell knows of smaller banks that already are deferring incentives thinking it is a best practice.

The Federal Reserve also is in the process of reviewing pay structures and may implement changes that will impact smaller banks as well, O’Donnell says. “I have a lot of concerns about what happens in the next year or two in terms of how they interpret and enforce new incentive practices because it will all cascade down,” she says.

Hilburn at F.W. Cook says much needs to be ironed out and exactly how it will impact smaller banks isn’t known. “There is going to be a shift in the mix of pay, to have less current incentives and more deferred incentives,” she says. “Directionally, they are going to move toward regional and local banks having more incentives with goal-setting.”

Smaller banks already know how to track loan portfolios and have tied bonus pay for loan officers to the performance of those portfolios before. But the general mood is shifting toward deferral of bonuses over a period of as many as three to five years, says Jim Bean, a principal at the McLagan consulting firm in Minneapolis.

“A deferral is a motivation to perform,” he says. “If you leave, the money is forfeited. So it encourages you to stick around. Generally, we think deferrals will include people who have a significant impact on an organization, such as senior executives and large producers or lenders.”

O’Donnell argues that deferral of short-term incentives isn’t necessarily a good thing. For example, telling a loan officer who might make only $16,000 in bonuses after taxes that he or she will have to wait a few years could be a real disincentive.

Even for executives it may be unnecessary, in the sense that long-term equity plans already could provide a balance to short-term pay, she says. What matters is the mix of short and long term pay, O’Donnell says. Bigger banks already are in large part deferring more than 50 percent of total long and short-term incentives, according to Compensation Advisory Partners.

Wells Fargo & Co. paid Chairman, President and CEO John Stumpf $12 million in performance-based restricted stock in 2011 that won’t start vesting, if at all, until 2014. His salary was $2.8 million and his short-term bonus was $3.1 million, which included restricted stock and cash. In a 49-page discussion of its compensation in its proxy statement, Wells Fargo said 67 percent of Stumpf’s 2011 compensation package was long-term versus currently available to him while 84 percent was at-risk based on future performance.

Starting in 2010, the company “consciously created a structure that takes the emphasis off of short-term pay and puts the emphasis on long-term performance,” says Justin Thornton, head of compensation and benefits at Wells Fargo. “We have always factored in risk outcomes to our compensation decisions, and our emphasis on long-term pay structures supports this approach.”

Unlike Citigroup, Wells Fargo managed to nab a 96 percent say-on-pay approval rating for its executive compensation plan.

Smaller banks also are making changes, although they’re not going as far as the big banks.

Alerus Financial, a privately owned $1.2-billion asset banking company in Grand Forks, North Dakota, took eight to 12 board meetings to decide on a compensation plan in 2009. The bank instituted clawbacks for executives’ bonuses and recently began tying cash bonuses to three-year performance periods instead of one year. If the bank performs in the top quartile of a peer group, the executive can get a bonus. That is a change from previous years when the bank looked at one year of performance and based the bonus on only one metric: net income. The bank also has a long-term equity plan with stock that vests over a five-year period.

“The board wants a plan that says the executives are paid for performance and they are at risk,” says Alerus’ chief executive officer and president, Randy Newman.

Gallagher, who advised Alerus on its incentive package, says in addition to looking at more than one year of performance for bonuses, he likes to tie bonuses to multiple metrics beyond profitability and including shareholder return. He likes to determine the bonus based on a comparison to a peer group of 15 or 20 banks.

“Then you look at the individual bank’s goals and that person’s individual performance,” he says.

Gallagher also thinks banks should defer total incentives over a one to three-year period.

Tim Reimink, a senior manager at Crowe Horwath LLP, thinks it is appropriate to defer pay for people who actually have some control over risk. He recommends, for instance, that commercial lenders be disqualified from bonuses if their charge-offs go above a certain level.

“Banks have become much more sensitive to not paying lenders incentives to increase their risk,” he says.

The employee needs to see a connection between how they perform and whether they get an award. Profit sharing builds camaraderie, but the individual can’t see how their own performance impacts the bonus, he says. Boards need to figure out what motivates individual groups of employees, he says. For example, stock options aren’t a big motivator for lower level groups of employees such as branch managers, O’Donnell says. Because their pay is lower than senior executives, they tend to need cash.

However, restricted stock that vests over time is popular for executives as a long-term performance incentive, and banks above $300 million in assets are starting to use them as they are popular with shareholders, the public and regulators, Bean says. (Privately owned companies may use “phantom” stock, a payment mechanism based on the value of the company’s stock.) Unlike stock options, which may be worth nothing if the bank underperforms for a long period of time, just as the banking industry has done for years now, restricted stock can provide an upside for the employees, crucial for retention.

In addition to restricted stock, clawbacks are becoming increasingly common and include ethical behavior as a condition, Bean says. Bad behavior can impact the company not just financially, but in terms of employee morale and the firm’s reputation.

“The fact is CEOs misbehave and it’s the responsibility of the board to act on that,” Bean says. “Shareholders really disapprove if I get $5 million in severance pay for behaving poorly.”

It’s important to do a peer review of compensation as well. “Make sure you have a current compensation peer group and you benchmark pay to the market,” Bean says. “It’s critical to make sure your compensation is current with the market for retention and recruiting.”

Risk management needs to be involved in structuring the pay plan ahead of time, and internal audit needs to be involved in making sure the metrics that are tied to the bonuses are accurate.

The boards also should analyze the total payout maximums for their different plans, to avoid unpleasant surprises, O’Donnell says. “A lot of boards don’t do this,” she says. “When they all pay out a lot of money, the boards say, ‘How did this happen?’ Look at the total payouts at a percentage of your net income as well.”

Make sure your decisions about structuring pay are well documented and you maintain a compensation committee completely independent from management, both in fact and in spirit, says Trevino. The New York Stock Exchange and NASDAQ OMX already require a completely independent compensation committee. With all this increased focus on risk and delayed bonuses, will banks that make changes have a tough time competing for talent with banks that don’t?

“I haven’t seen it impact recruiting,” Gallagher says. “Everybody has to do this. It’s not like it’s just one organization. If you have people who are really good, you don’t have to worry about them meeting these plans.”

He suggests taking time to come up with a really well thought-out incentive plan. There is no need to change the plan every year.

“It has to become a much more involved process,” he says. “It once took a week but now we’re seeing the whole process taking a month to a year.”