Bolstering Risk Management Through Pay Governance

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Risk management has been top-of-mind for bank leaders over the past year. Even before the bank failures in March, there was increased concern among bank leaders around several areas of risk. According to Bank Director’s 2023 Risk Survey, which was released in March but conducted in January 2023, respondents’ concerns about interest rate, credit and liquidity risks all increased markedly in 2023. Bank executives and directors also identified cybersecurity and compliance as areas where their concerns have increased.

Following recent bank failures and the subsequent increased scrutiny by regulators, risk management has become the top priority of the board. As such, compensation committees are fine-tuning how their incentive plan designs and governance processes consider risk management.

Six Ways to Bolster Risk Management Through Executive Pay Governance
Boards can deploy the following safeguards to mitigate risk in their banks’ executive pay programs and signal to external stakeholders that managing risk is a priority. In addition to being effective, each practice is reasonably straightforward to implement.

1. Risk scorecard review by the compensation committee. Absent formal risk-based metrics or a discretionary incentive plan, there are limited mechanisms for the compensation committee to account for risk management performance in a typical annual incentive plan. Presumably, the risk or audit committees review key risk metrics continually. In advance of reviewing the end-of-year financial performance under the incentive plan, the compensation committee reviews the same risk metrics as a first step, either independently or jointly with the risk committee. Based on that review, they can exercise discretion to reduce the payout under the financial results if sufficient rationale exists, such as liquidity concerns or capital deficiencies, among other items.

2. Risk adjustments at the individual level. The committee can adjust earned incentives for senior executives and other key positions, like head of mortgage lending, chief credit officer or chief technology officer, based on performance against risk management priorities within their scope of influence. If a risk management rating or evaluation is part of their individual performance rating or scorecard, they can use it to influence the individual performance factor or individual performance component in the scorecard. If there is no mechanism built into the plan for individual performance, the committee can apply a last-step risk evaluation to inform any negative discretion they may apply.

3. Building more informed discretion into the incentive plan. Though proxy advisors recommend a strict formula, the absence of some discretion in an incentive plan for banks could be rife with unintended consequences. Building in a discretionary adjustment factor with predefined categories for consideration and a specific range for adjustments, such as plus or minus 15%, can align pay decisions with business and risk factors that may not be represented in preset incentive scorecard goals. This provides a mechanism for the committee to consider headwinds, tailwinds and risk behaviors when interpreting results.

4. Risk event triggers in the clawback policy. Restatement triggers will be mandatory for public companies’ clawback policy by Dec. 1. In addition to restatement, misconduct triggers are also common across the industry, while clawbacks triggered by risk events are generally only prevalent among large financial institutions. Adding a risk-event trigger for gross negligence contributing to insolvency can provide a consequential penalty for failing to prevent the worst outcomes for banks of all sizes.

5. Deferred cash. Providing a deferred cash vehicle can align executive interests with creditors and depositors and appropriately balance the shareholder alignment already provided through equity compensation. The value of deferred cash can be indexed to changes in the bank’s book value or an appropriate interest rate to preserve value against inflation; dividends can also be credited during the vesting period, just like a stock unit. The executive becomes an unsecured creditor of the bank with additional incentives to use sound judgment while driving shareholder value.

6. Audit committee confirms the pay and performance of the top audit executive. Many of the charters for the audit committees at large financial institutions task the committee with conducting the annual performance review and approving compensation for the chief audit officer. Midsize and smaller banks could add a level of transparency in their processes and reinforce the independence of the audit function by doing the same.

Managing financial risk is at the core of the industry’s value proposition. In support of this, it is essential that the board oversees programs and processes that reinforce this priority. Employing best practices in a bank’s executive pay program and governance processes can reinforce sound risk management for years to come.

Incentive Plan Adjustments in the Current Challenging Environment

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2023 continues to be a challenging year for financial institutions. While banks planned for interest rate increases, few expected bank failures or immense pressure on deposit pricing. The recent bank failures and lower profitability outlook has been priced into the stock market, with the KBW Nasdaq Bank Index down nearly 20% year to date.

As a result, annual incentive payouts are trending lower than in recent years and the value of equity holdings has diminished at many banks. Award payouts are likely to be between threshold and target levels. The talent market, which has cooled somewhat, remains healthy and will pressure compensation committees to consider an appropriate balance of accountability, fairness and retention in incentive plan determinations.

2023 Annual Incentive Plans
Most compensation committees are taking a wait-and-see approach, given the continued uncertainty for the rest of the year. While they may be able to defend making certain adjustments now, companies generally get one opportunity to make a change. If banks modify their goals midyear and the institution’s financial performance worsens, it would be very challenging to justify further adjustments or use discretion at year-end.

We expect a variety of outcomes for 2023 annual incentive plans. We do not expect changes to the metrics or plan design at banks with incentive plans that use performance metrics that are less impacted by the interest rate volatility or have a discretionary component. However, for incentive plans that have been significantly negatively impacted, we may see year-end discretionary adjustments or broad use of strategic or individual components that place performance in the context of the external environment and provide payouts that are reflective of management’s action in 2023. Any discretionary decisions are likely to result in modest and below-target awards, given reduced bank earnings and negative shareholder returns.

There are several questions for the committee to consider in determining the use of discretion:

• Should the same payouts be provided to the executives as to the broader participants?
• Did management take effective actions in response to the challenging external environment? Could the risks have been managed more effectively?
• Have other adjustments been made to the plan in recent years (for example, reducing payouts when external factors increased earnings)?
• How did the bank perform on a relative basis versus industry peers?
• How will the adjustments or discretionary payouts be described in the proxy? Does the justification provide sufficient support for the ultimate payout levels?
• How is the bank expected to perform on proxy advisors’ quantitative tests? If lower results are expected and scrutiny is likely to increase, is the committee comfortable with shareholder outreach and defending the decision?
• How has the bank accrued for the bonus and what level of payout is affordable?

Outstanding Performance Shares
Unlike annual incentives, it can be more problematic for the compensation committee to adjust long-term awards with vesting that is contingent on achieving financial or shareholder return goals. Modifying these awards may lead to increased expense costs and disclosure requirements, as well as substantially more shareholder criticism and Say-on-Pay issues. Fortunately, many banks use relative performance metrics, which, by their nature, automatically adjust for macroeconomic circumstances. As a result, we anticipate few banks will modify outstanding performance shares unless applicable language is currently built into their performance metric definitions.

Determining award payouts in 2023 will be a combination of results and compensation committee discernment. Compensation committees should review the banks’ incentive plan language and determine the extent of flexibility, discretion and adjustment permissible. A robust dialogue, using the considerations above, will aid in striking an appropriate balance of accountability, fairness and retention.

Discretion in Incentive Plans: Taboo or a Must?

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Discretion is often considered taboo in the executive compensation world. Compensation committees that use discretion in determining incentive payouts risk receiving criticism from investors and proxy advisory firms, whose policies tend to prefer formulaic incentive plans. However, discretion is an important feature of many banks’ annual incentive plans that, if used appropriately, can enhance the pay and performance relationship.

There are two common annual incentive plan models used by banks: purely discretionary incentive plans and formulaic incentive plans.

At banks with purely discretionary incentive plans, the compensation committee determines annual incentives by conducting an assessment of company performance, considering both quantitative and qualitative criteria. There is no predefined formula, which gives the compensation committee flexibility to use a holistic approach and consider various factors to determine the payout. This approach mitigates the risk of overly focusing on any one performance metric to the detriment of overall performance and long-term success.

At banks with a formulaic incentive plan, the compensation committee determines annual cash incentives based on performance relative to predefined financial and nonfinancial goals that are set at the beginning of the year. While some banks rely solely on a formula, these plans often incorporate discretion in one or more of the following ways:

  • Weighted component: A portion of the bonus (such as 15% to 25%) is based on a review of quantitative and qualitative criteria.
  • Modifier: Annual incentive funding can be adjusted up or down (for example, up or down by 15% to 25%) based on a review of quantitative and qualitative criteria. Some banks also apply a modifier to individual payouts based on each executive’s accomplishments relative to individual performance objectives.
  • Adjustments to financial metric or overall funding: The compensation committee determines a reasonable adjustment to the financial metric or final payout to address the impact of unplanned events.

How Discretion Can Be Positive
A modest amount of discretion is a positive feature of a bank’s annual incentive plan. Discretion allows compensation committees to reward not only for what results were achieved but also how those results were achieved — including considerations like risk outcomes and regulatory compliance — and allows committees to adjust for factors that are outside of management’s control.
The compensation committee should define the performance criteria and articulate it to participants at the beginning of the year to inform a comprehensive evaluation of company and/or individual performance at the end of the year. One way for banks to implement this structured approach to discretion is to use a scorecard that allows the compensation committee to assess performance across multiple categories. A sample scorecard is outlined below:

Category Criteria

Financial Performance

 

·    Performance relative to plan/budget​

·    Performance relative to peers

·    Shareholder experience: Absolute and relative stock price performance

Customer/Stakeholder Experience

 

·    Customer relationships

·    Serving a diverse customer base

·    Investing in and supporting local communities

Operational Goals

 

 ·    Progress against strategic initiatives​ or key performance indicators (KPIs)
Environmental, Social, Governance (ESG)/Human Capital

·    ESG assessment

·    Develop pipeline of diverse leaders

·    Employee engagement scores

Risk Outcomes​/Regulatory Compliance

 

·    Risk and compliance assessments

·    Management of issues in a timely manner

·    Acceptable credit loss performance

Potential Challenges of Applying Discretion
It is important that pay outcomes reflect company performance and are aligned with the shareholder experience. The two most influential proxy advisory firms, Institutional Shareholder Services and Glass Lewis, prefer formulaic incentive plans for public banks and could criticize the use of discretion if they perceive a pay and performance misalignment. Banks can mitigate concerns by discussing the compensation decision-making process, demonstrating rationale for discretion and showing how pay and performance are aligned in proxy disclosure.

Incentive plans that are fully discretionary or that have significant discretionary components also put pressure on compensation committees to “get it right” at year-end. Establishing performance criteria at the beginning of the year and using a structured process with robust discussion to evaluate performance can help give the committee, executives and shareholders comfort with the outcomes.

Lastly, it is important to be consistent in applying discretion, adjusting for both unanticipated headwinds and tailwinds to avoid the perception that discretion means increased payouts in down years.

A formulaic incentive plan as the primary determinant of payouts continues to be the right approach for many banks. However, every bank should consider if there is a role for discretion in their plans to optimize alignment between pay and performance. Discretion provides the compensation committee with the flexibility to make decisions that reflect the overall performance of the bank while considering the impact of external factors on performance results and strategic accomplishments that may not lend themselves to formulaic assessments. In all cases where banks use discretion, it is important to have a robust and structured decision-making process to ensure transparency, fairness and consistency for both executives and shareholders.

Compensation Lessons in a Banking Crisis

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Between March 10 and May 1, three regional U.S. banks failed. How were these bank failures similar, or different, than the bank failures of the Great Recession? We already know that there will be more regulatory pressure on banks, but what lessons can these failures teach directors about compensation? First, it is important to compare the Great Recession to the 2023 banking crisis.

Credit Versus Liquidity
The Great Recession was defined by a general deterioration in loan credit quality, incentive compensation that overly focused on loan production and a lack of a risk review process that incorporated the role incentives and compensation governance played.

Contrast that to 2023: Banks have upgraded credit processes and their risk review processes to evaluate the role of incentive compensation under the 2010 regulatory guidance of sound incentive compensation policies. Unfortunately, the banks that failed did not have enough liquidity to cover depositors who desired to move their money.

General Versus Unique
The three failed banks had unique patterns that responded dramatically to the increase in interest rates by the Federal Reserve and complicated each firm’s ability to fulfill depositor withdrawals. Silicon Valley Bank’s bond portfolio was long duration, and First Republic had a material portion of its portfolio tied to long-term residential mortgages. In contrast to the Great Recession, this banking crisis has more to do with business model and treasury management than actions of mortgage or commercial lenders.

Poor Risk Review
This is one area of commonality between the Great Recession and 2023. The Federal Reserve’s postmortem report on Silicon Valley Bank noted that the institution’s risk review processes were lacking. Specifically, the bank’s incentive plans lacked risk measures, and their incentive compensation risk review process was below expectations of a $200 billion bank.

“The incentive compensation arrangements and practices at [Silicon Valley Bank] encouraged excessive risk taking to maximize short-term financial metrics,” wrote the Fed in its postmortem report. This is a responsibility of the board of directors: Examiners review the board’s incentive risk review process as a part of their effectiveness evaluation, as well as a foundational principle of sound incentive compensation policies.

Going Forward
Lessons for the compensation committee must include considerations for what should be in place now versus what committees should be thinking about going forward. The compensation committee should have a robust process in place that examines all incentive compensation programs of the bank in accordance with regulatory guidance.

This process should evaluate each incentive compensation plan according to risk and reward, and monitor how each plan is balanced through risk mitigating measures. In addition, the incentive review process should be governed by a sound overall incentive compensation governance structure.

This structure is anchored by the compensation committee and works with a management incentive compensation oversight committee. It should dictate how plans are approved, how exceptions to plans are made and when the compensation committee is brought in for review and approval. As an example, if a major change is made to a commercial lender incentive compensation plan midyear, what is the process to review and ultimately approve the midyear change? Regulators expect those processes to exist today.

But all crises present new learnings to apply to the future. While there are a number of lessons related to a bank’s business model and treasury management, there are also takeaways for the compensation committee.

Going forward, banks need to move their mindset from credit risk mitigators to overall risk mitigators in incentive compensation. Credit risk metrics are often found within executive incentive plans as a result of the Great Recession. Banks should think how they can incorporate overall risk mitigators, beyond credit risk, and how those mitigators could affect executive incentive plans.

A risk modifier could cover risk issues such as credit, legal, capital, operational, reputational and liquidity risk factors. If all these risks rated “green,” the risk modifier would be at 100%; however, if credit or liquidity turned “yellow” or “red,” this modifier could apply a decrement to the annual incentive plan payout. In this way, a compensation committee can review all pertinent risks going forward and help ensure incentive compensation balances risk and reward.

Lessons in Deferred Compensation

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Recently, NFP took the time to analyze several hundred executive benefit plans, and speak to bankers and consultants. With all that data, experience and untold hours of consulting on those plans, we identified some of the top issues — and unintended consequences — banks have encountered when it comes to compensation plans. Here’s what we’ve found, keeping the identities of our sources anonymous:

Banker’s Perspectives

  • Lifetime benefits. “Lifetime benefits are a throwback to the unsustainable pension days. Our former CEO retired in 2000 at age 65. He’s 87 and going strong, and we are expensing the full benefit every year.”
  • Vesting schedule. “I was wrong about the new 55-year-old CFO. He negotiated a three-year vesting schedule as part of an employment agreement and stated this was the last place he was going to work before retiring. He retired after three years, fully vested.”
  • Defined contribution versus defined benefit. “I wish we would have gone with a defined contribution approach versus a retirement-focused defined benefit plan. The long-time horizon is not very appealing to younger executives, and the board wished they had the ability not to contribute when times are tough.”
  • Interest crediting. “We tied the interest-crediting rate in our deferral plan to LIBOR +1%. I was informed later we could’ve had that provision ‘to be determined annually at the discretion of the board’ or even invested in numerous mutual funds. Flexibility from the start would have been better.”
  • Deferred compensation. “Our internal counsel referenced a future payment in an employment agreement subject to certain conditions. We accidentally created a deferred compensation plan. The missed Department of Labor notifications, unrecorded liabilities and missing claims language was a headache. We should’ve started with a complete plan from the beginning.”

Consultant’s Perspective

  • Inappropriate discount rate. A plan document had a stated rate of 9% to value the supplemental executive retirement plan, or SERP, liability and wasn’t pegged to an outside index. The audit firm did not question the rate for 10 years. The bank changed audit firms, and the new firm then determined the rate to be inappropriate for accounting purposes. This resulted in a dramatic increase in the liability that was greater than annual earnings, which triggered numerous issues.   
  • Offset issues. A SERP was designed in the early 2000s as a percentage of final pay, less the employer portion of the 401(k) and 50% of Social Security benefits. In the last few years prior to retirement, the executive stopped contributing to the 401(k) and missed out on the related employer match. There was also a significant market correction that resulted in a 401(k) balance that was much lower than projected, requiring the bank to record a large liability increase and the related expense to account for it.
  • Death benefit. A plan was intended to allow for accelerated future benefits in the event of death while employed, but the document referenced the current liability, not future benefit. An unexpected death occurred within six months of implementing the plan. The beneficiary received $10,000 instead of $200,000. Fortunately, there was a “key man” policy on the executive, and the bank chose to honor their original intent.
  • Disability. A plan’s payout terms in the event of a disability were the same as if the executive retired: a lifetime benefit. An executive became disabled for six months before dying. The plan paid out $20,000 over the six months, while the retirement benefit would have been $40,000 per year for life.
  • Change in control. During a plan design process, a bank wished to have maximum protection for executives recruited to start the bank, at their insistence. But they didn’t completely understand the change in control language as it pertained to vesting. The bank wanted to vest 100% in the accrued liability upon change of control, to be paid out when the executive separates service. They discovered during due diligence that the plan and the payout language did not match other provisions.. This created an unexpected “poison pill,” which greatly affected the purchase price. There was a lot of finger pointing.

No matter how long the compensation committee has been responsible for insurance or executive benefit plans, it’s not their full-time job. As fast as the industry and regulations are changing, it is impossible for decision makers to keep up on their own.

Working with a seasoned consultant who can leverage their expertise, resources and data analytics helps compensation committees make more informed decisions that have better outcomes, control costs and ensure that the bank, its directors, officers and executives are protected for the long term.

Insurance services provided through NFP Executive Benefits, LLC. (NFP EB), a subsidiary of NFP Corp. (NFP). Doing business in California as NFP Executive Benefits & Insurance Agency, LLC. (License #OH86767). Securities offered through Kestra Investment Services, LLC, member FINRA/SIPC. Kestra Investment Services, LLC is not affiliated with NFP or NFP EB. Investor Disclosures: https://bit.ly/KF-Disclosures

Top Priorities for Compensation Committees Today

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The compensation landscape in banking is constantly evolving, and compensation committees must evolve with it. We want to highlight three priorities for bank compensation committees today: the rising cost of talent, the uncertain economic environment, and the link between environmental, social, and governance (ESG) issues and human capital and compensation.

The Rising Cost of Talent
The always-fierce competition for top banking talent has intensified in recent years, especially in certain pockets like digital, payments and commercial banking. Banks are using a variety of approaches to compete in this market and make their compensation and benefits programs more attractive, including special one-time cash bonuses or equity awards, larger annual or off-cycle salary increases, flexible work arrangements and other enhanced benefits.

In evaluating these alternative approaches, compensation committees must weigh the value each offers to employees compared to the cost to the bank and its shareholders. For example, increasing salaries provides near-term value to employees but results in additional fixed costs. Special equity awards that vest over multiple years provide less near-term value to employees but represent a one-time expense and are more retentive.

We expect the “hot” talent market, combined with inflation, to continue applying upward pressure on compensation. However, the recent rate of increase in compensation levels is untenable over the long-term, particularly in the current uncertain economic environment. Banks will need to optimize other benefits, such as work-life balance and professional development opportunities, to attract and retain top talent.

The Uncertain Economic Outlook
In 2021, many banks had strong earnings as the quicker-than-expected economic recovery allowed them to reverse their loan loss provisions from 2020. As a result, many banks could afford to pay significantly higher incentives for 2021’s performance than they did for 2020’s performance. The performance outlook for 2022 is unclear. Inflation, rising interest rates and macroeconomic uncertainty will impact bank performance results in 2022. Results will likely vary significantly from bank to bank, based on the institution’s business mix and balance sheet makeup.

Compensation committees will need to consider how the push and pull of these factors impact financial results and, as a result, incentive payouts. Some compensation committees may need to consider adjusting payouts to recognize the quantifiable financial impact of unanticipated conditions outside of management’s control, like the Federal Reserve’s aggressive interest rate increases. Banks may find it harder to quantify the financial impact of other economic conditions, like inflation. As a result, many compensation committees may find it more effective to use discretion to align incentive compensation with their overall view of performance.
Bank compensation committees considering using discretion to adjust incentive payouts for 2022 should follow three principles:

1. Be consistent: Apply discretion when macroeconomic factors negatively or positively impact financial results.
2. Align final payouts with performance and profitability.
3. Clearly communicate rationale to participants and shareholders.

Compensation committees at public banks should also be aware of potential criticism from shareholders or proxy advisory firms. The challenge for compensation committees will be balancing these principles with the business need to retain key employees in a tight labor market.

ESG and the Compensation Committee
Bank boards are spending more and more time thinking about their bank’s ESG strategies. The role of many compensation committees has expanded to include oversight of ESG issues related to human capital, such as diversity, equity and inclusion (DEI). Employees, regulators and shareholders are increasingly paying attention to DEI practices and policies of banks. In response, many large banks have announced public objectives for increasing diversity and establishing cultures of equity and inclusion.

In an attempt to motivate action and progress, compensation committees are also considering whether ESG metrics have a place in incentive plans. In recent years, the largest banks have disclosed that they are considering progress against DEI objectives in determining incentive compensation for executives. Most of these banks disclose evaluating DEI on a qualitative basis, as part of a holistic discretionary assessment or as part of an individual or strategic component of the annual incentive plan. Banks considering adopting a DEI metric or other ESG metrics should do so because the metric is a critical part of the business strategy, rather than to “check the box.” Human capital is a critical asset in banking; many banks may find that DEI is an important part of their business strategy. For these banks, including a DEI metric can be a powerful way to signal to employees and shareholders that DEI is a focus for the bank.

Information Overload

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One of the biggest challenges facing all bank directors is the voluminous amount of information they need to read and comprehend before every board and committee meeting. More than a third of the board members responding to Bank Director’s 2021 Governance Best Practices Survey reported that not all directors review materials before board meetings — reducing the effectiveness of their boards.

Board and committee meeting packets — most of which are distributed electronically through secure board portals — can easily reach several hundred pages, particularly at large banks with complex operations. The packets are typically distributed several days in advance of board and committee meetings, often on a Thursday or a Friday, so directors have the weekend to read through them.

It is difficult to subscribe a best practice to board packets because they often reflect what board and committee members want to see. But there are certain standards that should apply. At a minimum, the board packet should provide a comprehensive overview of the bank’s performance, while highlighting any issues of concern that require the board’s attention. At the committee level, the packet should provide an overview of relevant areas that a particular committee is working on.

Packets should be well organized and include a complete agenda for each board and committee meeting, along with any supplemental information that is provided. There is a general tendency to provide more information than less, but it should be easily accessible to the directors.

It’s also important that the information be contextualized. The quality and utility of the information from a governance oversight perspective is generally more important than the sheer quantity of what’s being provided.

James A. McAlpin Jr., a partner and global leader of the banking practice group at Bryan Cave Leighton Paisner, says that board packets often include too much irrelevant information. McAlpin also sits on the board of Hyperion Bank, a $300 million asset community bank in Philadelphia. “I don’t need a listing of every new loan, because I don’t know these borrowers,” he says. “I need a listing of what the trends are. What is the net interest margin? What are the concentrations?” Concentration risk was a big problem for many banks during the financial crisis, McAlpin adds. “It didn’t happen over a period of one or two months, it happened over a period of time, and no one got it because no one was focused on that as a trip wire,” he says.

And the packets themselves shouldn’t be viewed as stone tablets that came down from Mount Sinai. Boards should periodically review whether the packets’ structure and organization, as well as the information being provided, still meets directors’ needs. “You may be comfortable with the board package, but when was the last time everybody, including your committee chairs, said, ‘Do we like the format? Do we like the information presented?’” says McAlpin. “‘What’s missing?’ Very few boards have that conversation.”

The board at Community Bank System, a $15 billion regional bank holding company headquartered in DeWitt, New York, meets 10 times a year. There is also a separate board for Community Bank, N.A., the holding company’s banking subsidiary. Holding company directors also serve on the bank board; the meetings occur back to back. Meetings of the board’s three standing committees — audit, compensation and governance — usually occur before the two board meetings.  Lead Director Sally A. Steele, who joined the board in 2003 and served as chair from 2017 to 2021, says the holding company and bank boards, as well as each committee, receive their own packet with a separate agenda and supplemental information.

There’s a lot to read before meetings, according to Steele. The audit committee packet in particular can be expansive, running to as many as 300 pages. The packets for the compensation and governance committees, as well as the holding company and bank boards, are generally smaller. But taken all together, Steele says, the information “can be really voluminous.”

Should a director attempt to read every single page if the board packet runs several hundred pages? That may be impractical — and perhaps unnecessary. Steele practices something that might be described as selective reading. “It depends on which [packet] you’re talking about,” she says. Steele is not a member of the audit committee and thus does not attempt to dig through that particular pile of information, even though she and all other non-audit committee members receive it. “Do the folks on [the audit] committee read all of it? I honestly believe they do. You can tell by the questions they ask,” she says.

As the board’s lead director, and previously as its chair, Steele reads both board packets in their entirety, as well as the packets of the committees she does serve on. “I would guess most directors focus on the committees they’re on, and the material that’s there, and then probably the bank board and holding company material,” she says. “It’s a lot of information.”

Steele believes it is the responsibility of every director to come to board and committee meetings well prepared. That includes having sufficiently reviewed the information that has been sent out in advance, even if members haven’t read every word. In fact, the Community Bank System board goes through an annual assessment process that is administered by its governance committee, and preparedness is a key part of the evaluation. “In our boardroom, it would not go over very well if people were not prepared,” she says. “I think it’s part of your fiduciary obligation to be prepared for meetings. Goes without saying.”

Plowing through an expansive board packet can be a challenging exercise for new directors who don’t have enough experience to prioritize what they must read word for word over what they can more lightly review. McAlpin believes it would be helpful if one of the more experienced directors “would offer to talk to them over lunch, or meet privately and go through the packet with them to get some sense of what has happened historically and what the packet is,” he says. “I think most boards do not do a very good job of new director orientation.

When Community Bank System recruits a new director, the board tries to lighten the new member’s load by assigning the individual to only one committee. But Steele sees no way around the fact that most new directors will have a steep learning curve, and that includes plowing through the board packet and knowing how to prioritize what’s in it.

“I’ve never found that you can have too much information,” Steele says. “There comes a point in time where you understand what’s important and what’s not. Then you get to choose if you feel it’s important enough for you to spend time on. … I just think there’s a price you pay for being a new director, and it’s figuring out and understanding what’s important and what’s not important.”

Practical Thoughts for the Evolving Role of the Compensation Committee

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Much has been written in recent months about the external forces accelerating investor, proxy advisor and employee focus on the topic of human capital management.

From the Securities and Exchange Commission Form 10-K human capital management disclosure requirement to a broader recognition from investors and insurers that people risk and opportunities are a material environmental, social and governance factor for every company — small and large — the compensation committee is even more central to a firm’s ESG strategy and journey than ever before.

Historically, the compensation committee charter duties were primarily focused on the chief executive officer’s  compensation and performance, as well as those elements for the broader executive officer population. However, as regulator and investor focus has shifted from executive compensation to broader human capital management, so too has the focus of many compensation committees.

In fact, many companies have changed the compensation committee name to reflect this expanded scope of duty: “Human Capital Committee” or “People Committee” are among some of the other derivations of these names. In fact, a majority of respondents in Aon’s Fall 2021 ESG Oversight Survey indicated that “human capital management” and diversity, equity and inclusion are formal duties of the compensation committee. Additionally, many companies have formally updated their charter documents to include oversight of human capital management and, increasingly, diversity, equity and inclusion related duties.

This expanded role into broader people risk and opportunities poses new challenges for the compensation committee. While compensation committees have gotten comfortable with external expectations surrounding executive compensation, the issue of broader workforce management requires a heavier coordination with corporate human resources teams. Like any  ESG topic, board or committee level oversight of a material ESG risk factor, such as human capital management, requires a clear definition of each group’s role, strong communication and information flow practices, along with an effective committee agenda list for each calendared meeting. The role of the compensation committee should not be to micromanage management teams on workforce planning, but to be informed enough on this topic to act as an independent, internal activist on the behalf of shareholders and employees.

Best Practice Considerations
With these aforementioned variables in mind, Aon recommends compensation committees consider the following best practice considerations heading into the 2022 proxy season:

  • Stay Informed. Stay current on regulations, investor expectations, and employee and market sentiment as it relates to the workforce. Use your compensation consultant or outside governance advisors to obtain necessary trends and information.
  • Ask the Right Questions. Be clear on what the company’s human capital and diversity, equity and inclusion-related goals are, and how they are tracking and defining success or failure. Know the extent to which such information is publicly disclosed or not, and understand if all such disclosures are consistent across all public forums.
  • Think Holistically. External observers are not looking at executive compensation decisions in isolation anymore. How your bank pays the CEO and other officers will be compared to how it treats the broader workforce. If you have lay-offs, furloughs or broader workforce compensation cuts, there will be an expectation that executive compensation be aligned with those broader actions. Stakeholders are evaluating executive compensation decisions in a broader context, so it is important to factor in all of these variables. It may also require greater coordination with the nominating and governance committee, if they own succession planning duties.
  • Give Yourself Credit. With human capital management being a material risk factor for virtually all industries, it is important to tell your story. If you do not proactively do this, someone else will — and it likely will not be favorable. Give yourself credit for the oversight, process, and practices that you have worked on with management to cultivate a meaningful human capital management strategy.

Structuring Incentive Compensation Plans for 2021

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Compensation committees wondering how to structure 2021 incentive compensation plans and goals should keep three principles in mind, says Laura Hay, managing director at Pearl Meyer, in a panel discussion focusing on compensation matters at Bank Director’s BankBEYOND 2020 experience.

Less complexity in a plan will bring more clarity to employees and the bank, she adds.

“Don’t overthink it,” she advises directors. “Think through what you’re trying to achieve and what would move the business forward.”

Plans should give employees “some control over the ability to control those outcomes,” she says, and should be developed with an eye toward the environment remaining uncertain for the time being. If a bank’s plan uses absolute metrics, which have performed particularly poorly in 2020, compensation committees may want to widen the performance range and reduce the absolute payout.

Hay was joined in this conversation with Bank Director CEO Al Dominick by Ken Derks, managing consultant at NFP Executive Benefits, and Todd Leone, partner and head of executive compensation at McLagan.

You can access all of the BankBEYOND 2020 sessions by registering here.

Key Compensation Issues in a Turbulent Market

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As compensation committee chair, Susan knew 2020 was going to be an important year for the bank.

The compensation and governance committee had taken on the topic of environmental, social and governance (ESG) for the coming year. They had conducted an audit and knew where their gaps were; Susan knew it was going take time to address all the shortfalls. Fortunately, the bank was performing well, the stock was moving in the right direction and they had just approved the 2020 incentive plans. All in all, she was looking forward to the year as she put her finished notes on the February committee meeting.

Two months later, Susan had longed for the “good old days” of February. With the speed and forcefulness that Covid-19 impacted the country, states and areas the bank served, February seemed like a lifetime ago. The bank had implemented the credit loss standard at the end of March — due to the impact of the unemployment assumptions, the CECL provision effectively wiped out the 2020 profitability. This was on top of the non-branch employees working from home, and the bank doing whatever it could to serve its customers through the Paycheck Protection Program.

Does this sound familiar to your bank? The whirlwind of 2020 has brought a focus on a number of issues, not the least of which is executive compensation. Specifically, how are your bank’s plans fairing in light of such monumental volatility? We will briefly review annual and long-term performance plans as well as a construct for how to evaluate these programs.

The degree to which a bank’s annual and long-term incentive (LTI) plans have been impacted by Covid-19 hinge primarily on two factors. First, how much are the plans based upon GAAP bottom-line profitability? Second, and primarily for LTI plans, how much are the performance-based goals based upon absolute versus relative performance?

In reviewing annual incentive plans, approximately 90% of banks use bottom-line earnings in their annual scorecards. For approximately 50% of firms, the bottom-line metrics represent a majority of their goals for their annual incentive plans. These banks’ 2020 scorecards are at risk; they are evaluating how to address their annual plan for 2020. Do they change their goals? Do they utilize a discretionary overlay? And what are the disclosure implications if they are public?

There is a similar story playing out for long-term incentive plans — with a twist. The question for LTI plans is how much are performance-based goals based upon absolute versus peer relative profitability metrics? Two banks can have the same size with the same performance, and one bank’s LTI plan can be fine and the other may have three years of LTI grants at risk of not vesting, due to their performance goals all being based on an absolute basis. In the banking industry, slightly more than 60% of firms use absolute goals in their LTI plans and therefore have a very real issue on their hands, given the overall impact of Covid-19.

Firms that are impacted by absolute goals for their LTI plans have to navigate a myriad level of accounting and SEC disclosure issues. At the same time, they have to address disclosure to ensure that institutional investors both understand and hopefully support any contemplated changes. Everyone needs to be “eyes wide open” with respect to any potential changes being contemplated.

As firms evaluate any potential changes to their executive performance plans, they need to focus on principles, process and patience. How do any potential changes reconcile to changes for the entire staff on compensation? How are the executives setting the tone with their compensation changes that will be disclosed, at least for public companies? How are they utilizing a “two touch” process with the compensation committee to ensure time for proper review and discourse? Are there any ESG concerns or implications, given its growing importance?

Firms will need patience to see the “big picture” with respect to any changes that are done for 2020 and what that may mean for 2021 compensation.