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.

Designing a Pandemic-Proof Compensation Plan

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The ability to pivot and adapt to a changing landscape is critical to the success of an organization.

The coronavirus pandemic has created a unique challenge for banks in particular. Government stimulus through the Paycheck Protection Program tasked banks with processing loans at an unheard-of rate, turning bankers working 20-hour days into economic first responders. Simultaneously, the altered landscape forced businesses to adopt a remote work environment, virtual meetings and increase flexibility — amplifying the need for safe and reliable technology platforms, enhanced data security measures and appropriate cyber insurance programs as standard operating procedure.

Prior to Covid-19, a major driver of change was the demographic shift in the workforce as baby boomers retire and Generation X and millennials take over management and leadership positions. Many businesses were focused on ways to attract and retain these workers by adapting their cultures and policies to offer them meaningful rewards. The pandemic will likely make this demographic shift more relevant, as the workforce continues adapting to the impending change. 

Gen X and millennial employees are more likely than previous generations to value flexibility in when and where they work. They may seek greater  alignment in their career and life, according to Gallup. The pandemic has forced businesses to either adapt — or risk the economic consequences of losing their top performers to competitors.

Many employees find they are more productive when working remotely compared to the traditional office setting, which could translate into increased employee engagement. In fact, the Gallup’s “State of the American Workplace” study finds that employees who spend 60% to  80% of their time working remotely reported the highest engagement. Engagement relates to the level of involvement and the relationship an employee has with their position and employer. Gallup finds that engaged employees are more productive because they have increased autonomy, job satisfaction and desire to make a difference. Simply put, increase engagement and performance will rise.

The demographic shift and a force-placed virtual office culture means that designing programs to attract and retain today’s workers require a well thought out combination of strategies. An inexpensive — though not necessarily simple — method of employee retention includes providing recognition when appropriate and deserved. Recognition is a critical aspect in employee engagement, regardless of demographic. Employees who feel recognized are more likely to be retained, satisfied and highly engaged. Without appropriate recognition, employee turnover could increase, which contributes to decreased morale and reduced productivity.

In addition to showing appreciation and recognizing employees who perform well, compensating them appropriately is fundamental to attracting and retaining the best. The flexibility of a non-qualified deferred compensation program allows employers to customize the design to respond to changing needs.

Though still relevant, the traditional Supplemental Executive Retirement Plan has been used to attract and retain leadership positions. It is an unsecured promise to pay a future benefit in retirement, with a vesting schedule structured to promote retention. Because Gen X and millennials may have 25 years or more until retirement, the value of a benefit starting at age 65 or later could miss the mark; they may find a more near-term, personally focused, approach to be more meaningful.

Taking into consideration what a younger employee in a leadership, management, or production position values is the guide to developing an effective plan. Does the employee have young children, student loan debt or other current expenses? Using personalized criteria, the employer can structure a deferred compensation program to customize payments timed to coincide with tuition or student loan debt repayment assistance. Importantly, the employer is in control of how these programs vest, can include forfeiture provision features and require the employee perform to earn the benefits.

These benefits are designed to be mutually beneficial. The rewards must be meaningful to the recipient while providing value to the sponsoring employer. The employer attracts and retains top talent while increasing productivity, and the employee is engaged and compensated appropriately. Banks can increase their potential success and avoid the financial consequences of turnover.

Ultimately, the pandemic could be the catalyst that brings the workplace of tomorrow to the present day. Nimbleness as we face the new reality of a virtual office, flexibility, and reliance on technology will holistically increase our ability to navigate uncertainty.

Using Succession Planning to Unlock Compensation Challenges

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compensation-9-16-19.pngSuccession planning could be the key solution boards can use to address their biggest compensation challenges.

Succession planning is one of the most critical tasks for a bank’s board of directors, right up there with attracting talented executives and compensating them. But many boards miss the opportunity of allowing succession planning to drive talent retention and compensation. Banks can address two major challenges with one well-crafted plan.

Ideally, succession planning is an ongoing discussion between executive management and board members. Proper planning encourages banks to assess their current talent base for various positions and identify opportunities or shortfalls.

It’s not a static one-and-done project either. Directors should be aware of the problems that succession planning attempts to solve: preparing future leaders, filling any talent voids, attracting and retaining key talent, strategically disbursing training funds and ultimately, improving shareholder value.

About a third of respondents in the Bank Director’s 2019 Compensation Survey reported that “succession planning for the CEO and/or executives” was one of the biggest challenges facing their banks. More popular challenges included “tying compensation to performance,” “managing compensation and benefit costs,” and “recruiting commercial lenders.”

But in our experience, these priorities are out of order. Developing a strategic succession planning process can actually drive solutions to the other three compensation challenges.

There are several approaches boards can use to formulate a successful succession plan. But they should start by assessing the critical roles in the bank, the projected departure dates of those individuals, and information and guidance about the skills needed for each position.

Boards should be mindful that the current leaders’ skill sets may be less relevant or evolve in the future. Susan Rogers, organizational change expert and president of People Pinnacle, said succession planning should consider what skills the role may require in the future, based on a company’s strategic direction and trends in the industry and market.

“The skills and experiences that got you where you are today likely won’t get you where you need to go in the future. We need to prepare future leaders for what’s ahead rather than what’s behind,” she said.

Once a board has identified potential successors, it can now design compensation plans that align their roles and training plans with incentives to remain with the organization. Nonqualified benefit plans, such as deferred compensation programs, can be effective tools for attracting and retaining key bank performers.

According to the American Bankers Association 2018 Compensation and Benefits Survey, 64% of respondents offered a nonqualified deferred compensation plan for top management. Their design flexibility means they can focus on both longer-term deferrals to provide retirement income or shorter-term deferrals for interim financial needs.

Plans with provisions that link benefits to the long-term success of the bank can help increase performance and shareholder value. Bank contributions can be at the board’s discretion or follow defined performance goals, and can either be a specific dollar amount or a percentage of an executive’s salary. Succession and training goals can also be incorporated into the plan’s award parameters.

Such plans can be very attractive to key employees, particularly the young and high performing. For example, assume that the bank contributes 8% of a $125,000 salary for a 37-year-old employee annually until age 65. At age 65, the participant could have an account balance equal to $1,470,000 (assuming a crediting rate equal to the bank’s return on assets (8%), with an annual payment of $130,000 per year for 15 years).

This same participant could also use a portion of the benefit to pay for college expenses for two children, paid for with in-service distributions from the nonqualified plan. Assume there are two children, ages three and seven, and the employee wants $25,000 a year to be distributed for each child for four years. These annual $25,000 distributions would be paid out when the employee was between ages 49 and 56. The remaining portion would be available for retirement and provide an annual benefit of $83,000 for 15 years, beginning at age 65.

Boards could use a plan like this in lieu of stock plans that have similar time horizons. This type of arrangement can be more enticing to younger leaders looking at shorter, more mid-term financial needs than a long-term incentive plan.

And many banks already have defined benefit-type supplemental retirement plans to recruit, retain, and reward key executives. These plans are very popular with executives who are 45 and older, because they provide specific monthly distributions at retirement age.

It is important that boards craft meaningful compensation plans that reward older and younger executives, especially when they are vital to the bank’s overall succession planning efforts and future success.

A Compensation To-Do List For Your Board

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Is your board effectively addressing the risk embedded in the bank’s compensation plans? McLagan Partner Gayle Appelbaum outlines a to-do list for boards in this video, and shares why new rules around hedging policies should be on your board’s radar. She also explains what banks need to know about these rules, along with considerations for your board’s annual compensation review.

  • Compensation Issues to Watch
  • New Rules on Hedging Practices
  • Other Practices to Address

Enticing Compensation Strategies In An Active M&A Market

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compensation-1-8-18.pngA recent Deloitte study indicates community bank merger and acquisition activity has been on the rise in 2018, though not necessarily at levels predicted by most experts.

A key benefit of a merger or acquisition is the resulting increase in talent for the surviving bank. Conversely, one of the greatest risks to consolidation is the loss of key employees; particularly talented loan officers. To mitigate this risk, many community banks ensure that director and employee benefit offerings are at or above the market.

The plans offered by the acquiring bank should not be perceived as non-competitive by the acquired talent they wish to retain.

Executive and director benefit plans are also part of the cost of consolidation. The latest report by community bank advisory group Vining Sparks highlighted several “hidden” costs of a merger or acquisition, including executive salary continuation plans (SCPs), director retirement agreements, stock options and employment contracts.

Acquiring banks need to understand the change-in-control stipulations outlined in such benefit plan agreements. These may include stay bonuses designed to retain critical staff through the closing of the consolidation, severance pay arrangements and accelerated accrual and payout requirements for certain nonqualified plans.

While retaining local talent after an acquisition is crucial to the acquiring bank, it should also be a consideration for banks who do not want to be acquired. The 2016 Bank Director M&A Survey found that 85 percent of banks sold because of shareholder liquidity, CEO/management succession, or board succession issues. One year later, Bank Director asked banks why they think they might sell in the future, 67 percent noted the same succession issues. Although many banks recognize succession issues as a driver, nearly 20 percent more of the banks who actually sold noted this as the main motivator.

Though it may be a challenge to find young local talent to establish an effective succession plan, banks can attract and retain the future leaders of their institution. Traditional bank deferred compensation plans, such as SERPs or SCPs usually interest the older generation. More creative plans, such as short-term deferrals and synthetic equity, can attract the younger generations.

When properly designed, short-term deferral plans can interest a young potential executive while simultaneously providing the bank with a hook to retain their services. Typically, a bank would identify a handful of potential candidates for the succession group and offer them a bonus that is deferred for a few years, and then pay out in cash. The bank continues to do so in subsequent years, building an account balance of 3-4 years of bonuses. If the employee leaves, they forfeit the bonuses. This strategy provides the employee with more immediate cash incentive, rather than waiting until retirement like traditional plans. It also gives the bank a few years to vet candidates of the successor pool. 

Synthetic Equity, such as Phantom Stock and Stock Appreciation Rights plans, is another approach banks utilize to align the interests of the executive with the success of the bank. Often, younger executives are not shareholders, but these plans are designed to make them feel and act like it. Simply stated, fake shares are awarded to each executive in the plan. These fake shares perform exactly like actual bank stock, giving the executive a stake in the success of the bank, while not diluting any actual ownership or voting rights of current shareholders.

Looking beyond 2018, short-term deferral and synthetic equity plans will certainly be among the more prevalent compensation plan designs in community banks, as the market continues to trend toward performance-based programs that more readily accommodate regulatory guidance. Plans are likely to include claw-back provisions and more deferrals of incentive pay that allow banks to take back all or a portion of incentive earned by an executive if the bank suffered losses, or was subjected to undue risk, as a result of the executive’s actions.

Bank owned life insurance (BOLI) continues to serve as the primary strategy used by community banks for recovering the costs of executive and director compensation plans. Rising employee benefits costs and competitive market pressures continue to challenge banks to explore unique and innovative ways to maintain profitability and growth while not abandoning their fundamentals.

BOLI helps a bank achieve this in two ways: tax-deferred growth of cash value (recorded as annual non-interest income) and non-taxable insurance proceeds paid to the bank at the time of death of the insured officer or director. These features of BOLI create an earning asset for the bank in addition to providing an effective means of informally funding executive or director compensation plans.

Solving the Puzzle of Compensation Plans and Diversity

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compensation-11-6-18.pngThere are some tasks that seem innocuous and administrative, but are nevertheless incredibly important. Assembling the puzzle pieces of effective executive and employee compensation plans is one such task.

This is why hundreds of bank executives and directors have assembled at Bank Director’s 2018 Bank Compensation and Talent Conference in Dallas, Texas, this week.

A number of themes began to emerge on the first day of the annual event, hosted at the Four Seasons Resort and Club at Las Colinas, the first of which is that many banks and their boards are still fully figuring out exactly how to structure executive and employee pay.

The starting point, according to a panel of experts from Compensation Advisory Partners and Kilpatrick Townsend & Stockton LLP during a morning workshop, is the interagency guidance issued in 2009 by the Federal Reserve, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency.

There are three overarching principles:

  • Provide employees incentives that appropriately balance risk and reward.
  • Be compatible with effective controls and risk-management.
  • Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

These may seem simple in theory, but the challenges for banks are real and complicated, which explains why compensation plans at so many banks are still a work in process.

On one hand, banks face one of the most competitive labor markets in decades, with the lowest unemployment rate in half a century. To attract talented workers, banks have to pay accordingly, which is why so many bankers raised their hands during a Monday morning workshop when asked if their banks boosted their minimum wages after tax reform passed Congress late last year.

On the other hand, as Steve Hovde, chairman and CEO of Hovde Group LLC, pointed out in his analysis of the industry, banks are facing well-seasoned business and credit cycles. This creates a quandary about how aggressive a bank should be in incenting rapid growth, as loans made at the top of an up cycle tend to be the first to go sour at the bottom of the next down cycle.

Moreover, while this may seem counterintuitive, there was wide agreement among attendees at the workshop that regulators aren’t currently focused on the design of compensation plans. The sole exception, according to at least one attendee, concerns how mortgage originators are being compensated, likely a reaction to the issues that surfaced two years ago at Wells Fargo & Co.

Another theme to emerge during the workshop involved diversity and inclusion initiatives, which all banks seem focused on addressing.

It’s important to distinguish between those two initiatives, observed one of the workshop’s panelists.

“Diversity is about inviting people to the party,” she noted. “Inclusion is about giving everyone an opportunity to dance.”

The challenge in banking, as in other industries, is tackling unconscious bias—social stereotypes people form outside their own conscious awareness.

No rational banker today would admit being biased against hiring or promoting women or minorities. Yet the demographic statistics in the industry speak clearly to a lack of diversity, especially at the upper levels of management.

One way to address this is simply through awareness. This was a point that Kate Quinn, the chief administrative officer of U.S. Bancorp, echoed two months ago at Bank Director’s Bank Board Training Forum in Chicago.

“Everyone has prejudices,” said Quinn at the time. “To address them, you first have to be aware they are there.”
And this isn’t just about hiring a diverse workforce; all employees must also be given an equal opportunity to excel. This is the distinction between diversity and inclusion in the corporate world.

An interesting point brought up during the workshop was that entry-level jobs throughout the financial industry tend to be fairly representative of the broader population. But as you look up the organizational chart, that diversity dissipates.

The lack of diversity at the top sends a strong signal, noted one attendee. Her point was, if, as a woman or minority, there isn’t someone like you on the board or who serves as an executive, then you are left with the impression you don’t have the same opportunity to advance.

Ultimately, though, if you listen to bankers, it’s clear that diversity and inclusion have become priorities at many institutions.
After all, to compete for talent, it’s not only how much you pay, it’s also the culture of your institution that will serve as a magnet for the next generation of employees.