Three Areas of Comp Committee Focus

Fall is executive compensation planning season. Board compensation committees are busy with familiar tasks, such as gathering performance data and establishing metrics for next year. But 2020 has been anything but typical, and based on recent discussions, we see three additional areas of concern in the months ahead:

  • Incentive pay adjustment
  • Next-generation leadership issues
  • Non-employee director pay

Typically, compensation committees are responsible for these issues. As they arise, committees should consider certain legal and tax implications, particularly when modifying existing compensation arrangements. If changes are significant or impact director compensation, the committee may be required — or may want — to obtain full board approval.

Short- and Long-Term Incentive Pay
Committees will undoubtedly confer with compensation advisors to determine adjustments to formulas and metrics, review comparison peer groups and evaluate the impact of Covid-19 on annual and multi-year performance measurements. When doing so, committees should also:

  • Review plan documents and employment agreements to avoid violating contractual terms. Committees should determine whether alteration of incentive pay could allow executives to terminate their agreements for “good reason.” Such terminations may entitle executives to severance benefits, and/or limit the scope of restrictive covenants.
  • Consider Code Section 409A. This is critical if modifications could be viewed as a replacement or substitution for other pay. These deferred compensation rules are wide ranging; even inadvertent violation can subject executives to significant income taxes, interest and penalties — potentially causing legal disputes.
  • Consider “golden parachute” issues under Code Section 280G. If a strategic transaction is in the near term, committees should carefully evaluate potential impacts on Section 280G calculations, including whether payable amounts could be nondeductible or taxable to executives.
  • Consider applicable disclosure requirements. Public banks may need to file a Form 8-K and determine how to communicate changes in future proxy statements. It is important to accurately disclose and explain changes to educate and engage with interested shareholders. In addition, public banks should evaluate any impacts on “grandfathering” under Code Section 162(m).
  • Evaluate any impacts on stock ownership guidelines. A decrease in equity grants or in share price (where guidelines are denominated in dollars) may hinder executives from satisfying the guidelines.

Next-Generation Leadership
Most banks are comfortable with their succession plans, allowing for a renewed focus on the next generation of bank leaders. The topic is challenging, particularly when considering the impact of Covid-19, and generational and cultural differences that influence the motivation of younger employees.

For years, these employees have requested more responsibility and less face time than required in office-centered cultures that were common at most banks as recently as March. The pandemic resulted in greater acceptance of such requests, making 2020 a valuable trial run for how well remote arrangements and more flexible schedules can work. Now is the time for banks to evaluate whether, and to what extent, they will embrace these changes, potentially obtaining a competitive edge.

In connection with next-generation issues, committees should:

  • Consider whether HR policies (e.g., company property, privacy, social media, business hours) are up to date.
  • Determine what incentives are most impactful — current compensation or future, potentially tax-deferred compensation.
  • Understand restrictive covenants to which external candidates are subject and the extent to which remote work interacts with their obligations.

Non-Employee Director Pay
Bank directors have been tasked with more and more since the financial crisis in 2007. With the pandemic, as well as environmental, social and governance concerns, this workload shows no sign of abating. Pay has not always kept pace with the workload and understandably, directors desire fair compensation for their time and efforts.

But director compensation decisions are subject to a strict “entire fairness” review, under which there has been significant litigation in recent years. Committees should obtain adequate legal advice and keep appropriate documentation with respect to all director compensation decisions, and consider obtaining full board approval for all alterations in pay.

Rewarding Executives for Successful Bank M&A


compensation-1-29-17.pngMergers and acquisitions (M&A) can create significant value for shareholders. Accordingly, bank executives should be rewarded when completing and integrating successful transactions. However, in today’s environment of heightened executive pay scrutiny, some approaches to providing additional compensation for M&A can result in criticism from shareholders and advisory firms such as Institutional Shareholder Services and Glass Lewis & Co. Clearly documenting the rationale of rewards and how they align with value enhancement can increase the effectiveness and shareholder support for such compensation.

Evaluate the Context

Roles of involved employees: While M&A activity is an expected part of some executives’ responsibilities, others may be required to go beyond their day jobs as part of the due diligence or integration processes. The extent of work required outside an employee’s normal responsibilities and job expectations should impact discussions of additional compensation.

Activities versus results: Another consideration is whether compensation should result from the additional, typically shorter-term activity during the M&A process or the actual longer term results of the transaction. In some cases, additional pay for transaction activities will be important to retain key talent who have been asked to go beyond their normal responsibilities. Larger, more significant rewards should depend on whether the merger produces improved bank performance and value creation.

Timing of additional compensation: Compensation can reward M&A results at different points during the transaction process. While the closing of the deal may be viewed as a trigger point for additional pay, the integration process is critical to ensuring the deal reaches its expected potential. Shareholders will be most concerned with the financial results generated from the transaction, and may be more receptive to additional compensation tied to the long-term financial impact of the deal.

Current programs: The current compensation program may already provide the opportunity to reward M&A, lessening the need for additional one-time pay that can be scrutinized.

Evaluate Rewards
There are many ways to reward M&A activity and results. Where possible, it is preferable to reward executives through existing programs, although special awards may be appropriate in some cases. Creating flexibility within the total pay program in advance of any transactions can help increase the number of tools the bank has to recognize executives. All of the potential components should be considered together since recognition may result from more than one of the following components:

Base Salary Adjustments: M&A activity can result in executives taking on new responsibilities, and pay increases may be appropriate. Since salaries can drive the size of incentive awards, considering the potential target total compensation of the new role can help ensure the executive is rewarded over the short and long-term.

Annual Incentives: Annual incentive plans can recognize short-term contributions and efforts during transactions and through integration. Depending on the plan’s structure, recognition could be incorporated as a component in a goal-based plan (i.e. based on strategic or individual performance) or as a consideration in a discretionary plan. Significant special cash bonuses solely for merger completion are not favored by shareholders.

Long-term Incentives: These programs are designed to recognize the long-term performance and value creation resulting from a company’s business strategy. Prior awards such as stock options and restricted stock will recognize stock price appreciation and shareholder views of the acquisition. Performance shares also recognize the long term value from successful transactions. The structure of the grant process should be considered. Is there flexibility to recognize individual contributions during the M&A process, for example, through a grant of stock? If so, this can be an effective way to reward contributions immediately, with compensation tied to shareholder value creation.

Special Awards: In some situations, additional, one-time awards may be appropriate. The best practice is to provide recognition in the form of long-term equity, preferably with some performance criteria or hurdle. This can help address concerns of some shareholders and advisory firms that are critical of M&A bonuses or grants.

Other Considerations: In more significant M&A transactions, it is appropriate to review the compensation peer group and assess whether compensation opportunities should be adjusted to reflect the new organization’s size and complexity. It is also important to monitor the pay-performance alignment over subsequent years to ensure compensation is appropriately recognizing performance.

Conclusion
Successful M&A, over the longer term, should result in commensurate rewards for the executives that execute the transaction. The key is ensuring that current pay programs have the flexibility to provide such recognition and that the pay levels, over time, are aligned with the company’s performance and shareholder value creation.

Designing The Bank’s Incentive Plan


12-6-13-Meridian.pngIncentive plans are a critical component of a bank’s compensation program. They help drive business results, provide competitive compensation opportunity and ensure an appropriate linkage between pay and performance. For publicly-traded banks, disclosure of incentive plans also serves as an important communication to shareholders of the bank’s priorities and commitment to pay-for-performance. With 2014 just around the corner, now is the time to determine the appropriate structure of your incentive plans for the new year.

Annual Incentives

Annual incentives help drive business results by linking compensation to the accomplishment of annual goals that support strategic priorities and ultimately create shareholder value. Key objectives of annual incentive plans include:

  • Driving business strategy – The choice of incentive measures and performance goals communicates to participants the results, behaviors and success factors needed to achieve business objectives. Banks should review their incentive plan measures each year to ensure they are aligned with the business plan and driving progress toward long-term goals.
  • Rewarding performance – Annual incentives should ensure that executives are appropriately rewarded for results. Plans should have threshold, target and maximum performance levels, with appropriate leverage in the payout ranges to ensure that reward levels are appropriate for the performance achieved (whether above or below expectations). Historical payouts should be assessed to determine if the plan is resulting in an appropriate pay-performance relationship.
  • Mitigating excessive risk taking – Bank regulators are focused on ensuring incentive plans, measures and payouts ensure participants are not incentivized to take excessive and/or inappropriate risks. This assessment should be conducted annually and whenever a new plan or changes are being proposed.

Choosing the right performance measures is essential to ensure that annual incentives support the key business objectives. While earnings (e.g., earnings per share, net income) is the primary focus for most bank annual incentive plans, including additional measures ensures a more balanced plan and provides the opportunity to directly link incentives to strategic priorities. Depending on a bank’s priorities, it may be appropriate to focus on growth, expense control, capital levels and/or credit quality.

It is also important to consider to what extent the annual incentive plan will reward performance at the company, business line and individual levels. Typically, a higher percentage of annual incentives are based on bank-wide results for senior executives to reinforce the team approach. Incentive plans also can provide some level of individual accountability by allocating goals specific to each executive’s role. Executives should meet to discuss their respective individual goals for the upcoming year to ensure appropriate coordination and interaction as needed.

Long-Term Incentives

Long-term incentive plans, which are typically delivered primarily through equity awards, should motivate and reward the creation of long-term shareholder value. Long-term incentive plans do this by enhancing alignment with shareholders, rewarding sustained long-term performance and creating retention “hooks” for high performers through the value of unvested awards.

Banks can choose from a variety of vehicles to deliver long-term incentives, including time-based restricted stock, stock options, performance shares (restricted stock that requires achievement of performance goals to vest) and long-term cash plans. Each vehicle has its own strengths and weaknesses in accomplishing the objectives of long-term incentive programs. Stock options and performance shares promote shareholder alignment and performance, while time vested restricted stock promotes stock ownership and retention goals. Most banks seek a balanced approach that allows them to achieve the multiple goals discussed above. As a result, an increasing number of banks are choosing a portfolio approach to long-term incentives, providing on average two components (e.g. stock options and time-based restricted stock or performance shares and time-based restricted stock).

For awards with performance vesting criteria, incentive measures should represent shareholder return or long-term value creation. Performance measures can be based on absolute results, relative comparisons to other banks or both. Absolute goals should align with a bank’s strategic plan. Relative measures avoid the challenge of multi-year internal goal setting, but require the selection of an appropriate comparative group of banks.

Conclusion

Given the significance of incentive plans, it is important to begin discussions about the design of programs well in advance of the new performance year. Banks should ensure that their programs support strategic objectives, motivate participants to drive the success of the bank and align pay outcomes with performance results. Annual evaluation of prior year results can also ensure plans are effective and provide input for realigning the plans if appropriate.

The Changing Landscape for Incentive Pay


10-25-13-Blanchard.pngHistorically, bank employees have enjoyed a culture where employees had a feeling of entitlement to generous annual salary increases and profit-sharing bonuses merely for continuing to work for the bank. That is changing. Performance based cultures that reward shareholders and employees and allow transparent communication of expectations and results are becoming more prevalent.

Creating compensation plans that provide a transparent link between actual organizational performance and executive pay is now the rule rather than the exception. Several aspects of the Dodd-Frank Act encourage pay for performance, including mandatory clawbacks of unearned compensation, transparency of incentive compensation agreements and shareholder say-on-pay advisory votes. The increasing influence of shareholder advisory groups (primarily Institutional Shareholder Services and Glass-Lewis) have driven public banks to change executive compensation practices to reflect pay for performance.

Private banks also are shifting executive compensation practices as their regulators look for best practices in executive compensation. Blanchard Consulting Group’s 2012 Executive Benefits Survey showed that 59 percent of banks said regulators reviewed executive compensation plans and practices during the exam. Blanchard Consulting Group’s 2013 Compensation Trends survey found that 63 percent of banks have modified executive compensation incentive plans in at least one of the last three years based on the changing bank regulations.

Compensation transparency at the executive level as well as emphasis on cost containment (salary and benefits costs are generally the largest budget expenditure for a bank) are supporting a larger overall bank cultural shift away from “pay for loyalty.”

Creating a Performance Based Culture

What can your bank do to start to support a sales and performance based culture? Creating a bank-wide annual incentive plan (AIP) with individual employee goals that “roll-up” to the executive AIP goals is one alternative. For example, in the lending department, all the loan officers’ portfolio loan growth goals at target performance levels should add up to the overall bank target loan growth goal. Your bank can also affect change with strategic use of the annual salary increase budget. For example, your bank may target a 3 percent salary increase for all employees. Instead of just giving all employees a 3 percent increase, many banks are now using position on a salary range and performance reviews to give more of a salary increase to high performing employees or those that are meeting performance expectations and are low on the salary range. There is an opportunity for strategic salary budget use, especially with the recent economic hardship that certainly broke down employee entitlement thinking around salary increases. Many banks froze salary increases or bonuses or both during 2008 to 2010. This practice as well as bank failures, mergers and acquisition activity, reduction in force, and hiring freezes gave employees a clearer sense of how their pay and job security is affected by overall bank performance.

Impact on Executive Officer, Producer and Staff Level Incentive Plans

Both executive and non-executive incentive plans are being structured to meet several different planning objectives including the following:

  • Earning opportunities under executive officer incentive plans should be reasonable and capped, as cash incentive plans with unreasonably high payout opportunities may motivate executives to take excessive risks or manipulate earnings.
  • Incentive plans that relied historically on profitability or income goals are adding strategic and/or asset quality goals that focus on long-term viability.
  • Many banks with producer plans that pay out frequently are moving to annual payouts and considering holding back/deferring a portion of the incentive payout until it can be determined that a loan will not become problematic.
  • Mortgage lender compensation restrictions by the Federal Reserve and Dodd-Frank prohibit banks from paying mortgage lenders incentives that are based on fees.
  • Many banks are now including a long-term incentive component in executive pay-for-performance programs to help mitigate regulatory concerns that executives focus exclusively on short-term goals.
  • Today, the most common form of long-term incentive for publicly traded banks is restricted stock, which is viewed more favorably by the new regulations and guidelines. Restricted stock typically provides a stronger retention device than stock options and typically provides lower stock dilution rates.
  • Many private banks will use phantom stock and/or performance-based deferred compensation programs when real stock is not available.
  • Stock ownership guidelines and holding requirements (especially in public banks) are viewed favorably by regulators and shareholders.

Incentive compensation programs have experienced increased scrutiny in recent years. However, performance based compensation seems to be more useful than ever. Banks need to be more strategic and many are trying to drive a performance turnaround. To that end, identifying, quantifying, and driving the right performance plan can play a critical role and can differentiate your bank and your high performing employees from the competition.

Designing Annual Incentives to Improve Pay for Performance


10-2-13-Pearl-Meyer.jpgAnnual incentive programs are one of a bank’s most important tools for executing a meaningful pay-for-performance philosophy. The degree to which they drive strategic priorities and shareholder value depends on three important design dimensions:

  • The selection of performance measures
  • The degree of difficulty built into performance goals
  • How payout levels are calibrated with different levels of performance

The Banking Edition of Pearl Meyer & Partners’ On Point Survey: Annual Incentive Plans for Top Corporate Officers provides insight to the most common practices as reported by 31 banking institutions (representing 22% of the total survey group), the majority of which are publicly-traded. Among the findings:

Banks typically build their annual incentive around three to five key financial measures. The most common performance measure, used by 58 percent of bank survey participants, is net income (including earnings per share or EPS). Operating income is the second most common measure, used by 46 percent of respondents, and top line revenue or sales is used by 31 percent. In addition to financial measures, most banks use individual performance to either modify the calculated bonus amount (45 percent) or independently generate a portion of the annual incentive amount (23 percent).

Performance goal-setting is arguably the most difficult and also one of the compensation committee’s most important responsibilities. Fifty-five percent of banking participants base annual performance goals on the board-approved budget. Among those banks that do not reference the budget, 26 percent reported using long-term internal standards (e.g., 1 percent return on assets, or 10 percent earnings growth) and 10 percent each used either long-term strategic plan objectives or other forecasts.

In addition to a target goal, 71 percent of respondents establish a threshold/minimum goal and a superior/maximum goal as a consistent percentage (e.g., 80 percent and 120 percent) of the target performance goal each year. While defining a consistent range around target is a reasonable approach, institutions should take care to evaluate the degree of difficulty of goals each year—120 percent of budget may be a reasonable goal in one year, but extremely aggressive in another year. Also, 120 percent of budget will be a more or less aggressive level of performance depending on which financial measure is used.

Only 7 percent of banking participants consider other factors in setting goals, such as degree of difficulty relative to peers/industry expectations and/or the level of performance expected by shareholders. In addition to evaluating approved goals externally relative to peers and industry performance, as well as shareholder expectations, every compensation committee should also understand the difficulty of achieving goals relative to the bank’s internal historical performance and planned investments and expenditures during the year.

Almost all annual incentive plans are designed to pay out 100 percent of the target award opportunity for achievement of the target performance goal. However, survey respondents reported much more variety in maximum payouts for achievement of superior goals—ranging from 19 percent of respondents with a maximum payout of 100 percent of target (i.e., no upside leverage above target performance), to another 19 percent of respondents with a maximum of 150 percent or 200 percent of target. Payout levels for threshold and superior performance should be adjusted to appropriately reflect the degree of difficulty for achieving each goal. For example, a plan design in which threshold performance to achieve any award at all is 90 percent of target goal should have a higher payout (perhaps 60 percent of target) than if the minimum threshold to achieve any award is 70 percent of the target goal. (In this case, perhaps a 20 percent payout would be appropriate.)

Conclusion

An effective annual incentive plan links and appropriately calibrates performance goals and payout opportunities, taking into account the degree of difficulty involved in meeting goals. Moreover, as part of good plan design, compensation committees should understand how the goals relate internally to the bank’s historical performance results and anticipated future investments, and externally relative to peer performance and shareholder expectations. By taking such steps, companies can improve the strength of their performance-pay relationships.