Regulators Are Back: What to Watch in Compensation Plans

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After taking more than a decade to finalize pay-for-performance compensation rules, the U.S. Securities and Exchange Commission now expects companies to take about six months to comply with them. 

“There will be a lot of computers blowing up in the next several months,” says Todd Leone, a partner at the compensation consulting firm McLagan, an Aon company. “There’s a lot of eye-rolling that we didn’t have much time to do this.” 

Leone was speaking to a group of more than 250 human resources professionals, directors and industry leaders attending Bank Director’s Bank Compensation and Talent Conference, taking place November 8 through 9 in Dallas. The new SEC disclosure rule is one of a host coming down the pipeline for publicly traded companies. Leone says the agency introduced 26 new proposals so far in 2022, the highest it has been in five years. 

“It’s turned into quite a big to-do,” says Susan O’Donnell, a partner at Meridian Compensation Partners, who also spoke about the pay-for-performance regulation on stage. 

After years of little activity finalizing what languished in the Dodd-Frank Act of 2010, regulators under President Joe Biden have taken renewed interest in adopting rules that will impact a broad swath of mostly public companies. In 2015, the SEC first proposed rules to require companies to disclose more about the relationship between executive pay and performance. In August, the SEC adopted the rules, which go into effect for fiscal years ending on or after December 16, 2022. In other words, most public banks will be required to provide the new disclosures starting in the 2023 proxy season. Smaller reporting companies are subject to scaled disclosure requirements. 

“I think that this rule will help investors receive the consistent, comparable, and decision-useful information they need to evaluate executive compensation policies,” SEC Chair Gary Gensler said in a statement at the time. O’Donnell says companies will have to report executive compensation alongside financial performance metrics, including total shareholder return, as well as TSR of a peer group, net income and a financial performance metric chosen by the company. In all, the company will be required to report three to seven financial performance metrics. 

This could cause problems for banks that complete M&A deals, Leone says. Typically, net income falls after an acquisition because of one-time expenses. At the same time, compensation increases, sometimes to motivate the executive team to make the deal a success. He recommends banks include a description in the disclosure that describes why pay and performance may not appear to align.

“Institutional investors aren’t looking at this to tell them anything they don’t already know,” Leone says. “The one area where we’re scratching our heads is what are the plaintiffs’ lawyers going to do. You have to make sure there’s a story behind this and a narrative that you’re telling.” The first year, Leone says companies will have to disclose three fiscal years of compensation metrics, so he advises companies to get started now on 2020 and 2021 calculations. Each year, another year will be added, until companies report five years’ worth of data. 

Companies will have more time to comply with the other recently finalized disclosure rule required by the Dodd-Frank Act, this one having to do with clawing back incentive compensation that was granted in error. Leone referred to the rule as “lovely bedtime reading for those of you with insomnia,” because it encompasses more than 200 pages. 

In October, the SEC finalized the rule that had first been proposed in 2015 requiring companies to disclose their policies regarding clawing back compensation from named executives. Usually, those clawbacks occur due to restatements of earnings or misconduct. Although the rule doesn’t say that clawbacks must occur for misconduct, the rule does require companies to claw back compensation that was based on erroneous calculations, regardless of whether the executive was at fault for the error. Leone expects the rule to go into effect later in 2023. Smaller reporting companies do have to comply with this one. 

And the third disclosure rule coming down the pike for public companies is Nasdaq’s new board diversity rule. Laura Hay, lead consultant for Meridian Compensation Partners, says the exchange will require companies to have at least one diverse director starting in 2023 and two starting in 2025, or explain why they don’t have them. Diversity may include gender or underrepresented minorities, as well as LGBTQ individuals.

The exchange also requires that companies include a diversity matrix in their disclosures, which went into effect in August for the next proxy season.

2022 Compensation Survey: Complete Results

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Bank Director’s 2022 Compensation Survey, sponsored by Newcleus Compensation Advisors, surveyed 307 independent directors, chairs, CEOs, human resources officers and other senior executives of U.S. banks below $100 billion in assets, with the majority of respondents representing regional and community banks. Members of the Bank Services program have exclusive access to the full results of the survey, including breakouts by asset category, ownership structure and region.

The annual survey benchmarks CEO pay and compensation for independent directors and non-executive chairs, and supplements respondent input with data collected from 96 public banks. This year, it also examines a competitive talent landscape, and CEO succession and performance. The survey was conducted in March and April 2022.

Click here to view the complete results.

Key Findings

Talent Challenges
Managing compensation and benefits costs (46%), paying competitively (40%) and recruiting commercial lenders (34%) have emerged as respondents’ top compensation-related challenges this year. While half say their bank added staff over the past year, 78% say that it was harder in 2021 to attract and keep the talent their bank needs.

Banks Pay Up
Banks almost universally report increased pay for employees and executives. Of these, almost half believe that increased compensation expense has had an overall positive effect on their company’s profitability and performance. Forty-three percent say the impact has been neutral.

Lenders In Demand
Seventy-one percent expect to add commercial bankers in 2022, which is almost certainly driven by a desire to grow commercial portfolios and offset expense growth. Over half of respondents say their bank did not adjust its incentive plan for commercial lenders in 2022, but 34% have adjusted it in anticipation of more demand.

Additional Talent Needs
Banks also plan to add technology talent (39%), risk and compliance personnel (29%) and branch staff (25%) in 2022. Respondents also indicate that commercial lenders, branch and entry-level staff, and technology professionals were the most difficult positions to fill in 2020-21.

Image Enhancement
Forty percent of respondents say their organization monitors its reputation on job-posting platforms such as Indeed or Glassdoor. Further, 59% say they promote their company and brand across social media in an effort to build a reputation as an employer of choice, while just 20% use Glassdoor, Indeed or similar platforms in this manner.

CEO Turnover
Sixty-one percent of respondents indicate that they’re not worried about their CEO leaving for a competing financial institution, while a third report low to moderate levels of concern. More than half say their CEO is under the age of 60. Respondents report a median total compensation spend for the CEO at just over $600,000.

Remote Work Persists
Three quarters of respondents say they continue to offer remote work options for at least some of their staff, and the same percentage also believe that remote work options help to retain employees. Thirty-eight percent of respondents believe that remote work hasn’t changed their company’s culture, while 31% each say it has had either a positive or negative impact.

BOLI Administration: What Comes Next?

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Setting up the right Bank-Owned Life Insurance (BOLI) policy is only part of the story. What happens over the life of the policy is important, too. In this informative video, Jim Calla of Meyer-Chatfield explains how proper maintenance and reporting can make the most of this product.

  • Why is proper BOLI administration an important issue for banks?
  • What are the characteristics of a good BOLI administrator?

The Impact of Rising Interest Rates on BOLI

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BOLI-7-9-15.pngSince the Great Recession of 2007-2009, the Federal funds rate has been held near zero to help spur the U.S. economic recovery. However, with the decline in the unemployment rate, strong jobs growth in the second quarter of 2015 and low inflation, the Federal Reserve may begin to raise short-term interest rates before the end of this year.

Although no one can predict exactly when interest rates will rise or by how much, we all understand it will occur at some point. Because we have been in a low interest rate environment for so long, the natural question is how will higher market interest rates impact the credited interest rates on bank-owned life insurance (BOLI) policies?

To understand the impact of rising interest rates on BOLI carriers offering fixed-income products, it is first necessary to understand the carriers’ investment philosophies, portfolio compositions and interest crediting methodologies. Although the investment philosophy of each BOLI carrier differs, there are generally some common threads. The investment objective of most BOLI carriers is to build a diversified portfolio of securities across and within asset classes with a long-term orientation that optimizes yield within a defined set of risk parameters. The portfolio strategy often targets investment grade securities, both public and privately issued, with cash inflows that reasonably match the projected cash outflows of their projected liabilities. Corporate bonds are usually the largest holding in the portfolio along with commercial mortgages/mortgage backed securities, private placements, government/municipal bonds and other holdings. The duration of these portfolios is typically four to ten years.

Insurance companies use different interest crediting methodologies for BOLI business. Some carriers use a portfolio approach while others use a new money rate approach. In most cases, the carriers who use a new money rate approach blend it into the portfolio over time. The crediting rate in products from new money rate carriers is based on the carrier’s expected rate of return on premiums received currently. The crediting rate in products from portfolio rate carriers is based on a combination of the rate of return from new premiums as well as the balance of the general account assets of the company or the assets of the specific BOLI portfolio.

Rising interest rates will affect both new BOLI cases as well as existing BOLI policies. As noted above, insurance companies invest heavily in bonds. When market interest rates rise, yields on new bonds will increase while prices on existing bonds will decline. In anticipation of rising interest rates, some carriers shorten the duration of their portfolios or pursue a hedging strategy to manage risks.

Carriers using the new money approach will see a more immediate and positive impact on their initial credited rate for new BOLI policies as their rates, for newly issued policies,  are based on current investments yields. Assuming a modest increase in rates, carriers using the portfolio approach may see little or no immediate change in their rate, but will likely see an increase in their credited interest rate over time. This will occur as the portfolio turns over and as new premium that is received is invested at a higher rate.

For existing general account and hybrid separate account BOLI policies, whether a new money or portfolio approach was used, there is no mark-to-market risk as the insurance company, not the policyholder, bears the price risk. For new money products, the interest rate credited to a new purchase is not likely to increase for several years after purchase since the underlying investments supporting the new money purchase typically have durations of four to ten years. Assuming slow and steady interest rate increases, both new money and portfolio products will likely increase over time with the portfolio products expected to increase more rapidly than the new money products. This is because the portfolio products will receive more new cash flows to invest at the higher rates.

A significant interest rate increase over a short period of time may cause most new premium to be placed in new money products, thereby reducing the new premium received into a portfolio product and slowing the time period it takes for the crediting rate to grow to market levels. If this were to occur, the crediting rates on portfolio and new money products would be expected to increase at about the same pace.

Please also bear in mind that it is important for directors and senior management of a bank to monitor not only changes in credited interest rates, but also the net yields. The net yield reflects the actual credited rate less mortality charges and, in some cases, policy fees or other administrative expenses. Accordingly, it is possible for one carrier to have a higher interest rate than another, but a lower net yield.

Many BOLI service providers will meet with their clients at least once a year to discuss the status and performance of their policies. At that meeting, it is vital for board members and senior management to review, among other things, the net yield earned on their policies to determine whether those yields are competitive in light of the type of policy purchased (new money, portfolio, blended portfolio) and current market conditions. Your service provider is well positioned to help you with that analysis and discussion of options, if changes are needed.

In conclusion, rising interest rates will occur at some point, but are likely to have a favorable interest rate impact on both new and existing BOLI clients using a fixed account over the long-term.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

Employee Stock Ownership Plans: Another Tool for Family-Owned Banks

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ESOP-06-19-15.pngToday’s economy presents numerous challenges to community bank profitability—compressed net interest margins, increased regulation, and management teams fatigued by the crisis. In response to these obstacles, many boards of directors are exploring new ways to reduce expenses, retain qualified management teams, and offer opportunities for liquidity to current shareholders short of a sale or merger of the institution.

For many family-owned banks, their deep roots in the community and a desire to see their banks thrive under continued family ownership into future generations can cause these challenges to be felt even more acutely. In particular, recruiting and retaining the “next generation” of management can be difficult. Cash compensation is often not competitive with the compensatory packages offered by publicly-traded institutions, and equity awards for management officials are unattractive given the limited liquidity of the underlying stock. All the while, these institutions should ensure that their owners have reasonable assurances of liquidity as needs arise or as investment preferences change. In combination, these challenges can often overwhelm a family-owned bank’s desire to remain independent.

Depending on the condition of the institution, implementing an employee stock ownership plan, or ESOP, may help a board address many of these challenges. While the ESOP is first a means of extending stock ownership to the institution’s employees, an ESOP can have other applications for family-owned banks.

Recruitment and Retention
An obvious benefit of an ESOP is to provide management and employees the ability to participate in an increase in the value of the bank, aligning their interests with those of shareholders. An equity interest provides economic incentives to join or stay with the bank and the ownership interest provided by ESOPs to employees has been shown to improve workforce productivity and morale.

Source of Liquidity for Shareholders
Without significant trading activity in their stock, shareholders of a closely-held institution may seek a liquidity event, which can include the sale of their shares to a third party or a merger with another bank. For these institutions, using the ESOP as part of a stock repurchase plan or to buy out selected shareholders can provide a buyer for large blocks of stock at a reasonable price.

For family-owned institutions, the tax benefits associated with a sale of a family’s interest in the institution to management via an ESOP are considerable. Most individual sellers of stock to an ESOP (and some trusts) qualify for a tax-free rollover of the proceeds of that sale into domestic stocks and bonds of U.S. corporations which meet certain limits on passive income. Under certain circumstances, this tax-free rollover opportunity avoids all federal income and capital gain taxes on the sale of shares to an ESOP.

In order to fund large purchases, the ESOP can take on a limited amount of leverage in order to acquire more shares in a particular year than can otherwise be allocated to plan participants. Before taking on this leverage, the bank should carefully consider how much leverage it can actually handle relative to the contributions that are expected to be made to the ESOP.

Special Benefits for S Corporations
ESOPs can also reduce shareholder numbers to facilitate a company’s conversion to an S corporation, which can help significant shareholders avoid the double taxation of dividends that apply to C corporations. Under the Internal Revenue Code, an ESOP counts as only a single shareholder for purposes of S corporation limitations, no matter how many employees have shares allocated to their accounts in the ESOP. Upon a plan participant’s separation from service from the institution, the participant may be entitled to only the cash value of the shares, rather than the shares themselves.

ESOPs also benefit from the S corporation status given their exemption from federal and most state income taxes. Since ESOPs are tax-exempt entities, they do not pay income taxes on their share of the institutions’ income like other shareholders do. When S corporations make distributions to their shareholders, ESOPs can retain that distribution, giving a better return to the ESOP participants. Additionally the cash reserves held in the ESOP from these distributions can be used to pay down ESOP debt incurred to buy shares for the ESOP, fund additional stock purchases by the ESOP, or to fund employee withdrawals from the ESOP.

For a variety of reasons, ESOPs can help family-owned financial institutions better manage the challenges of today’s market by providing a more liquid market for the institution’s shares and an exit strategy for some significant investors short of a sale or merger. ESOPs can also improve employee and senior management engagement and retention at a relatively low cost, which can improve the institution’s bottom line. With careful implementation and board oversight of compliance efforts, ESOPs can be a powerful tool for many community banks.

What Is Bank-Owned Life Insurance (BOLI)?

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You may have heard the term BOLI before, but what is Bank–Owned Life Insurance? How can it benefit your bank?

In this insightful video, Charlie Hicks of Meyer-Chatfield explains what BOLI is, how it works and breaks down the ins and outs of this investment product.

  • What is BOLI?
  • What are the benefits of BOLI?
  • How does BOLI work?
  • Is there information on how the tax-free status of BOLI will be impacted by BASEL III?