Are Your Executive Compensation Programs Providing Effective Retention Hooks?

8-18-14-meridian.pngWhen it comes to executive compensation in banking, the importance of retaining great employees often gets short shrift to discussions of pay-for-performance and what the regulators want. However, retaining top performing executives can be critical to a bank’s success. Following are four important questions all compensation committees should be discussing.

Why is retention important?
Developing a strong, high-performing executive team takes time. High-performing executives drive the development of the bank’s strategy and its execution. The unexpected departure of a key executive can create disruption and potentially lead to the departure of customers and other employees. Replacing those executives can often be a time-consuming and expensive proposition.

Compensation committees should also focus on succession planning, and retaining high-performers plays an important role. The next generation of leadership can be a target of competitors looking to strengthen executive talent. It is important for banks to identify top performers with the potential for greater leadership roles in the future, and ensure their compensation is structured to encourage them to remain and develop their skills within the bank.

How do you assess the level of retention in your programs?
An assessment of the retention hooks within your executive compensation program should include the following:

Pay Opportunity: Do your high performing executives have market-competitive compensation opportunities and incentive programs that are viewed as challenging but reasonable? High performers want to be rewarded with an effective performance-based structure.

Value of Unvested Compensation: Do high performing executives have meaningful value in unvested compensation that would be forfeited if they left and difficult for another bank to replace? This can often be assessed by analyzing the following:

  • Value of unvested compensation (e.g. deferred cash incentives, equity awards): Committees should regularly evaluate the value of outstanding awards at the current stock price to see if it is meaningful enough to retain key executives. While there are no specific guidelines, executives often have outstanding awards greater than their annual salary, with top executives generally significantly higher.
  • Retirement benefits: While the use of enhanced retirement benefits such as SERPs (Supplemental Executive Retirement Plans) for executives has been declining, it remains important to understand the value provided through your retirement programs, vesting milestones and integration with other retention instruments (e.g. stock).

Development Opportunities: Do high-performers know they are viewed as critical to the organization’s future and are they given opportunities that allow them to further develop? Retention is about more than just compensation.

How can we enhance the retention value of our programs?
There are several design features that can enhance retention:

Choice of Long-Term Incentive Vehicle: While there has been a significant shift towards the use of performance-based vesting, an over-emphasis on this vehicle can potentially create retention concerns–particularly if there is uncertainty in the potential payout (e.g. goals are set too high, and payouts are not seen as being likely). An overemphasis on stock options can create similar concerns since executives have less direct influence on stock price. Time-based restricted stock, when used in moderation, can be useful in ensuring some value will remain outstanding for executives while continuing to have the amount vary based on shareholder value.

Vesting of Equity: Irregular vesting schedules can result in uneven retention value from year-to-year, while annual grants with overlapping vesting schedules help ensure that executives always have meaningful value outstanding. Cliff vesting of large retention awards can also create concerns if the value of outstanding awards declines significantly after they vest.

Retirement Provisions: It is also important to understand the retirement provisions of your awards, as full vesting at an early retirement age will diminish the retention value of your program once executives meet retirement eligibility.

Retention is most effective when incorporated into the overall program, rather than as special one-time “make up” grants, which banks may need to give to executives when the existing program fails to provide adequate retention value.

How does retention fit into the rest of our program’s objectives?
Balance is critical in executive compensation programs. Retention is just one of several important objectives of an effective total compensation program. In addition to ensuring that your programs encourage retention of high-performing executives, compensation committees also need to ensure compensation programs are aligned with the bank’s strategy, link pay outcomes with performance, align executives with shareholders and avoid encouraging excessive risk.

Managing the BOLI Risk

Bank-owned life insurance (BOLI) is a popular investment asset that can be used as an added benefit for key executives. For example, a portion of the death benefit may be allocated to the executive. The returns can be used to offset employee expenses such as health care or 401(k) plans. The percentage of U.S. banks holding BOLI continues to grow year after year. The percentage increased from 53.4 percent in 2012 to 56.4 percent in 2013, says David Shoemaker, a principal at BOLI provider Equias Alliance. He talked to Bank Director magazine recently about market trends and what boards should know about risk management of BOLI plans.

Why are banks buying BOLI today?
BOLI continues to offer a higher after-tax yield than most other investments of similar risk and duration. The extra income boosts capital and can aid growth or provide higher shareholder dividends. In a standard general account or hybrid separate account BOLI product, there are no mark-to-market adjustments on the bank’s books. BOLI interest rates are variable and will generally follow changes in market rates (but on a lagging basis), making them more advantageous than fixed-income products in a rising interest rate environment.

What are the risks that a bank should pay attention to?
As part of its annual risk assessment review, the bank should review the current and long-term performance of BOLI as well as the financial condition of the carriers. BOLI regulations going back to 2004 state that banks should perform their own analysis and not just rely on ratings. The Dodd-Frank Act highlighted the importance of this as well.

What impact will Basel III have on BOLI?
Basel III will not have any impact on general account BOLI policies, which are backed by the credit of the insurance company and carry a minimum interest guarantee and a risk weighting of 100 percent. However, hybrid separate account policies, which are also backed by the insurance company, offer additional benefits such as multiple investment accounts that are legally protected from creditors of the carrier. Typically, these policies are assigned risk-weights as low as 20 percent or as high as 100 percent. Under Basel III, our understanding is the bank has the option to evaluate each security in the portfolio individually, which would be a time consuming and expensive task, or may save time and money and simply risk weight the BOLI asset at 100 percent.

What are the responsibilities of the board when it comes to risk management of the bank’s BOLI program?
It is the responsibility of management and the board to make sure there is proper oversight of the BOLI program. The bank should have a BOLI policy that details the bank’s purchase limits for one carrier and for all carriers in aggregate. The policy should outline the processes for performing the pre-purchase due diligence as well as the ongoing risk assessment reviews. The board should have a reasonable understanding of how BOLI works and the risk factors associated with it, including credit and liquidity risk. If the bank owns a variable separate account product, additional due diligence should be performed since it is a more complex product.

Regulators are worried about the risk posed to banks by third-party vendors. How does this impact banks with BOLI?
One of the key messages in the regulatory guidance is that banks should adopt risk management processes commensurate with the level of risk and complexity of the third-party relationship. With regard to BOLI and non-qualified benefit plan design and administration, I believe banks will move increasingly to providers that offer a high level of technical support, including CPAs, attorneys and analysts, and that have significant internal support systems to aid in designing and servicing non-qualified benefit plans as well as BOLI. Companies will want to deal with providers that have internal controls independently tested and certified with a report known as Service Organization Control (SOC) 1 Type 2, through the American Institute of Certified Public Accountants’ SSAE 16 standards.

David Shoemaker is a registered representative of, and securities are offered through, ProEquities Inc., a Registered Broker/Dealer, and member of FINRA and SIPC. Equias Alliance is independent of ProEquities Inc.

How Directors Get Paid: What to Know if You are on the Compensation Committee

8-4-14-Blanchard-article.pngBank directors have experienced an increased workload in recent years with many new regulations and compliance guidelines. It is now more important than ever to ensure the total compensation program for your directors is competitive and linked to the bank’s overall compensation philosophy. In addition, it is important that your bank has an independent compensation committee that ensures that the compensation programs for both executive officers and directors are designed appropriately.

How Directors Get Paid
Once banks become profitable, they typically begin to pay cash fees to the board of directors to compensate them for the time they spend on board activities. Many banks have adopted a “pay-for-time” director compensation philosophy that is based on participation in board and committee meetings. These meeting fees can range from a couple hundred dollars to thousands of dollars per meeting with larger banks typically paying higher per meeting fees. Since the chairman of the board and the chairmen of committees typically spend more time preparing and presenting, these positions will often receive 20 percent to 30 percent more compensation per meeting than regular board or committee members.

In addition to per meeting fees, many banks use retainers in the form of cash to compensate directors. Retainers can be useful to attract directors in competitive markets when meeting fees may not provide enough to retain high quality professionals.

Paying Long-Term Incentives
Cash bonuses for directors are not considered a best practice in the banking industry. Best practices from the National Association of Corporate Directors state that the board should not receive compensation based on the achievement of annual performance metrics, as the board should be focused on making decisions for the long-term success of the bank. In place of annual cash-based incentives, the suggested incentive for the board is in the form of stock grants or cash-based deferred compensation programs such as phantom stock for private corporations, where compensation is given based on the bank’s long-term increase in book value. These types of long-term incentive plans have replaced or supplemented many of the cash retainer programs.

Paying Benefits to Directors
Director health and welfare programs are not common in the industry, as most insurance and retirement programs for directors are cost-prohibitive. A cost-effective benefit for directors is a voluntary deferred compensation plan where directors can defer their cash fees or retainers to retirement or an agreed upon date. The cost of these plans to the bank is any above-market interest rates applied to these types of deferred compensation programs, which typically makes this the most affordable benefit for bank directors.

The Importance of Compensation Committee Independence
Typically, the compensation committee is made up entirely of independent outside directors, which is now a requirement for publicly traded banks under the new Securities and Exchange Commission (SEC) compensation committee governance rules. These rules dictate that an independent director must not be an officer or employee of the company or its subsidiaries or any other individual having a relationship that, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

Hiring Independent Advisors
The SEC also is now requiring public banks to conduct an independence assessment of individuals who are advisers to the compensation committee. Prior to retaining or receiving the advice of any advisor, we believe all compensation committees should ask the following questions to assess independence:

  1. Does the advisor offer any other services to the bank that are paid by management?
  2. Are the amounts paid to the advisor a significant portion of the advisor group’s total revenue?
  3. Does the advisor have any business or personal relationship with a member of the compensation committee or an executive officer?
  4. Does the advisor own any stock of the company?

Director compensation programs are becoming more of a strategic focus in the banking industry as the workload and risk associated with being a bank director has increased. Also, there are more requirements now for the compensation committee to be aware of. It is more important than ever to ensure that the total compensation program for your directors is competitive and is in line with the compensation philosophy of the bank, and that the bank is following compensation rules. This will help ensure that the bank attracts and retains high quality directors to help direct the bank to future success.

BOLI Growth Continues: Latest Trends in Bank-Owned Life Insurance

7-23-14-Equias.pngBanks and, particularly, community banks, continued to increase their purchases of bank-owned life insurance policies (BOLI) in 2013. Banks are taking advantage of attractive BOLI yields compared to alternative investments, and they are motivated as well by increased liquidity and low interest rates. BOLI provides tax advantaged investment income not available with traditional bank investments. Banks earn income from the growth of the BOLI cash value and from the life insurance proceeds paid to the bank on the death of the insured employee. In addition, BOLI can help offset and recover employee benefit expenses.

Industry Studies
Each year, IBIS Associates, Inc., an independent market research firm, publishes a report analyzing BOLI sales based on information obtained from the insurance companies that market BOLI products. According to the most recent IBIS Associates BOLI Report:

  • Life insurance companies reported that they sold 1,235 new BOLI cases in 2013, up 12 percent from 2012, representing about $3.18 billion in premium in 2013. The 1,235 cases included banks purchasing BOLI for the first time as well as additional purchases by banks that already own BOLI.
  • Of the $3.18 billion in premium sold last year, 59.6 percent was put into general account, 31.8 percent was put into hybrid separate account and 8.6 percent was put into variable separate account.
  • The average premium per case was about $2.57 million, a 20 percent increase from last year.
  • Banks with assets of $250 million to $1 billion purchased the largest number of products last year (42.3 percent of cases).

Based on a review of FDIC data, the Equias Alliance/Michael White Bank-Owned Life Insurance Holdings Report published in 2014 for the year 2013 shows that:

  • Of the 6,812 banking institutions in the U.S., 3,840 or 56.4 percent held BOLI assets in 2013. However, if you exclude banks with less than $100 million in assets from the equation, the percentage of banks holding BOLI jumps to 64.9 percent.
  • BOLI assets totaled $143.84 billion at the end of last year, reflecting a 4.3 percent increase from $137.95 billion at the end of 2012. However, banks with between $100 million and $10 billion in assets had an increase of 7.8 percent in their BOLI assets from 2012 to 2013.
  • The fastest growing plan type in 2013 was hybrid separate account (which combines many of the best features of a general account and variable separate account product). Almost 1,200 or 30.9 percent of the 3,840 institutions reporting BOLI assets held all or part of their funds in the hybrid separate account. Assets in this type of account grew 9.1 percent from 2012 to 2013 while general account assets grew 6.1 percent during that same time and variable separate account assets increased only 1.9 percent.
  • Although the largest portion of BOLI assets was held in variable separate account polices (49 percent of total BOLI assets), this plan type was used by the fewest number of banks. The bank bears the investment risk under this type of plan rather than the insurance company. Further, the number of banks holding variable separate account BOLI assets increased only slightly from 593 at the end of 2012 to 597 at the end of 2013.

Current BOLI Net Yields
BOLI provides a competitive net yield, currently in the range of 3.0 percent to 3.9 percent after all expenses are deducted, depending on the carrier and product. This translates into a tax equivalent yield of 4.84 percent to 6.29 percent, assuming a 38 percent tax rate. Carriers can reset crediting rates annually or quarterly depending on the type of BOLI product used.

In summary, the number of banks purchasing BOLI continues to grow. The tax-deferred interest generated by a fixed income BOLI policy is typically substantially higher than a bank can earn on other investments with a similar risk profile, especially in the current rate environment. Further, income generated by BOLI can help offset the ever increasing costs of a bank’s health care, retirement and other benefit programs.

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

Loan Officers in High Demand Across Banking Industry

6-13-14-Comp-survey.pngThe imperative to grow revenues, particularly in today’s highly competitive lending environment, has replaced regulatory compliance as the driving force behind board agendas and executive hiring decisions, according to the findings of Bank Director’s 2014 Compensation Survey. With many regulatory rules now long-established, banks are focusing again on the business of making money—and for most banks, that means making loans.

For many bank boards, particularly for larger institutions with more than $1 billion in assets, there are also indications that director compensation is rising. However, at a growing number of banks, director pay is shifting from per-meeting fees to annual retainers. And despite improved stock valuations across the industry, directors and executives alike express a clear preference for cash over equity.

More than 300 directors and senior executives of banks nationwide responded to the survey, sponsored by Meyer-Chatfield Compensation Advisors. The survey was conducted by email in March and April, and additional data on director pay was collected from the proxy filings of publicly traded banks for fiscal year 2013.

Key Findings:

  • Board pay is rising, and most directors, at 61 percent, feel that they are paid fairly. Almost half of the respondents have seen director pay increase within the last two years, and 40 percent expect director compensation to increase in 2015. However, 42 percent of respondents from the smaller banks, less than $500 million in assets, haven’t raised board pay since 2010 or prior.
  • Opinions are mixed on the value of equity. Fifty-five percent of respondents believe that equity is highly valued by executives, while only 43 percent feel that equity compensation is highly valued by directors. Forty-one percent of banks overall, and 65 percent of publicly traded institutions, report that the bank’s CEO receives equity grants.
  • Benefits are rising. Indicating a possible reversal of a trend in declining board benefits, 54 percent indicate that the board members of their bank receive some sort of benefit, an increase of almost 30 percent from 2013. Reimbursement of travel expenses, at 34 percent, is the most common benefit reported by participants, followed by deferred compensation at 28 percent.
  • Lending, compliance and risk executives were the focus of new hires and promotions in 2013. Loan officers, at 44 percent, are in strong demand at banks of all sizes, and an emphasis on top line growth drove almost 60 percent of all executive level hires. Executives with expertise in risk management accounted for 59 percent of hires at banks with more than $5 billion in assets, with a lesser demand for this skill set at smaller institutions.
  • Does culture and stability trump money when it comes to attracting new talent? Corporate culture, at 69 percent, and the stability of the company, at 53 percent, were cited as the top elements that make a bank attractive to potential hires. Just 13 percent cited the compensation program.

Tying compensation to performance remains a key challenge for bank boards as they work to develop compensation plans that will balance shareholder interests while still rewarding employees. As a renewed focus on growth makes loan officers even more desirable, the onus is on the board to stay on top of today’s compensation trends.

Download the summary results in PDF format.

How Regulators are Changing Bank Incentive Pay

6-9-14-meridian.pngThe Federal Reserve’s influence on incentive practices at the largest banks is cascading to regional banks. Although the final Dodd-Frank Act regulations have not been released, many banks are adjusting their incentive programs to respond to regulatory pressure. A Meridian Compensation Partners review of proxies of U.S. banks with $10 billion to $400 billion in assets confirmed that changes continue to emerge in the following areas:

Decreased stock option use.
While slightly more than half (53 percent) of banks continue to include stock options in their portfolio of long-term incentives, the value of such awards declined 30 percent from 2012. Regulators deem stock options as a more risky form of compensation. Most banks granted two to three forms of equity as part of their long-term incentive program in 2013, with stock options representing the smallest portion.

Increased use of performance-based equity.
In place of stock options, performance-based shares have become the most prevalent stock instrument, used by 74 percent of the banks. Performance shares reward future performance, typically over three years, against measures such as total shareholder return (42 percent of those surveyed used TSR), return on equity (38 percent used), earnings per share and return on average assets (both used by 27 percent). Some banks used multiple measures to determine performance share awards.

Reduced use of relative metrics.
For performance-based equity plans, relative performance metrics continue to be prevalent, particularly due to the challenge of setting long-term goals in today’s business environment. Yet, regulators fear overuse of relative metrics leads to risk taking and “chasing” of performance peers. As a result, we are seeing an increase in the use of absolute measures in long-term plans: 17 percent use absolute measures and 46 percent use a combination, while 37 percent continue to use only relative.

Reduced leverage.
Over the last few years, regulators have been pressuring the largest banks to reduce the maximum upside opportunity in incentive awards, particularly within long-term plans. While maximum opportunities of 200 percent of target remain standard in general industry, 125 percent to 150 percent caps are now standard at large banks.

Increased prevalence of forfeiture provisions.
While clawbacks have emerged as common practice despite the lack of final Dodd Frank rules regarding clawbacks, these policies will be challenging to enforce. It is easier to adjust pay before the award or vesting, rather than after pay has been doled out. About 30 percent of banks have forfeiture provisions on incentives prior to award or vest. Such provisions allow for potential reduction of outstanding cash and equity grants in instances of negative earnings, returns, and/or “bad risk behavior.” Many banks provide for the adjustment or forfeiture of equity vesting based on an assessment of individual actions (e.g. violation of risk policies).

While some of these emerging trends conflict with the desires of shareholders and other constituencies to reward high performance, they nevertheless represent reality for today’s banks. As organizations consider these practices, it is critical to take a holistic view of the bank’s compensation philosophy and programs to ensure they are balanced, support the business strategy, align pay and performance and appropriately mitigate risk. Incentive plans should:

  1. Be grounded in bank strategy. Performance measures should clarify and communicate what’s important to focus on (short and long-term) as well as the level of performance expected.
  2. Incorporate a balanced portfolio of performance perspectives. No one measure effectively reflects performance. Annual incentive measures should align with your bank’s annual business plan while long-term incentive measures should reflect sustained value creation and shareholder value. Banks should understand the total incentive opportunity (short and long-term) that is allocated to different performance perspectives (e.g. profitability, growth, shareholder return, individual performance) to ensure it reflects the desired mix and focus.
  3. Balance discretion and formula. While the Securities and Exchange Commission and shareholders like to understand the performance goals and resulting performance to assess pay-performance alignment, regulators prefer discretion, particularly with respect to risk considerations. More banks are using a combination of financial measures and discretion to provide a more holistic review of performance.
  4. Incorporate risk adjustments. Consider forfeiture provisions that provide for reduced payouts or clawbacks.

Making Benefit Plans Work: It’s All in the Contract

5-2-14-equias.pngTo attract and retain key executives, banks have implemented nonqualified benefit plans as part of their overall compensation strategy. One of the challenges of bank board members is to understand what is or is not included in these agreements and how the agreement terms affect other agreements such as change-in-control, employment contracts, equity plans and others.

Prevalence of Nonqualified Plans
Such plans are common in the banking industry. According to the American Bankers Association 2013 Compensation and Benefits Survey, 64 percent of banks surveyed offer some kind of nonqualified deferred compensation plan for top management (CEO, C-Level, EVP), and 45 percent of respondents offer a Supplemental Executive Retirement Plan (SERP). Types include performance-driven benefit plans, director retirement plans, death benefit or survivor income plans, and phantom stock or stock appreciation rights (SARS) plans.

To avoid violating the U.S. Department of Labor rules concerning plan eligibility, participants in nonqualified plans should be limited to a “select group of management or highly compensated employees,” which taking a conservative approach, is typically no more than 10 percent of a company’s employees. In addition, the included employees should have the ability to affect or substantially influence the design and operation of their deferred compensation plan.

It is important for the board to understand the terms of their deferred compensation plans and the potential ramifications. Common questions that arise regarding some key agreement terms are:

  • What happens if the executive chooses to retire early or extend the time to retirement? Generally the benefits are payable at the time the executive separates from service. Depending on the plan design and the board’s intent, the benefit amount for delayed retirement may remain the same or may be increased.
  • What happens in the case of involuntary termination or termination-for-cause? Termination-for-cause provisions often include forfeiture of some or all of the benefit.
  • What happens if the executive becomes disabled? Some plans provide that payments commence upon separation from service due to disability while some commence at normal retirement age.
  • What type of vesting is common in plans? Since nonqualified plans are not governed by ERISA (Employee Retirement Income Security Act), they may use a number of different vesting options including: immediate, graded, cliff, rolling, or at-retirement. Vesting will vary depending on the objectives of the plan, tenure of the executive and annual expense accruals required.
  • What type of non-compete/non-solicitation terms are included? Some agreements include a definition of these terms, although many banks include them in separate agreements which should be consistent. The length of the non-compete/non-solicitation period as it relates to a nonqualified plan is typically 12 to 36 months, but may last as long as the benefit is being distributed.
  • Nonqualified benefit plan agreements should be reviewed together with other compensation related agreements, such as those mentioned above. So-called “golden parachute rules” are discussed in a previous article and are a perfect example of why a thorough review of all such agreements is critical.

Agreements generally include other terms such as pre- and post-retirement death, change-in-control, and form and timing of payment.

Key items to consider/evaluate when reviewing plans and agreements include:

  • Are key terms consistent with other implemented agreements such as employment agreements, change-in-control agreements, non-compete/non-solicitation, long term incentive plans and equity plans?
  • Has the total cost of a change-in-control based on the agreement provisions, including the accelerated vesting of benefits, been calculated and discussed with the board?
  • Are the plans properly documented in accordance with IRC Section §409A as appropriate, which governs deferred compensation plans?
  • Does the plan provide a meaningful benefit to the participant? Many plans were designed at a time when the benefit was meaningful, but the participant’s role and compensation may have significantly changed.

Nonqualified benefit plans will remain an important piece of the overall compensation strategy to attract and retain key officers, but it is critical to design meaningful and effective plans and ensure the plan documentation language is clear and avoids conflicts with all employment and benefit-related agreements. For deferred compensation plans subject to IRC 409A, there is limited ability to change the form and timing of payments after implementation; therefore, it is critical to work with experienced professionals who can help make sure you get it right the first time.

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

Now is the Time to Test and Report Your Pay and Performance Relationship

2-14-14-Meridian.pngCreating alignment between pay and performance is critical in today’s environment of executive pay scrutiny. However, understanding how to assess the relationship and communicate it effectively can be challenging. There are many different methodologies and perspectives that should be considered. Following are several important considerations for testing and reporting the alignment between executive compensation and performance.

Testing the Relationship

Assessing the relationship between pay and performance requires establishing methodologies for calculating pay and evaluating performance, as well as determining the time period to analyze.

The most traditional view for reviewing the pay and performance relationship reflects actual compensation granted, which includes base salary, annual incentive paid and grant date value of long-term incentives. While this is consistent with proxy reported information, it does not reflect actual pay received nor a full picture of performance.

We believe multi-year analyses (e.g. over three and five years) that focus on actual value of compensation earned provides a broader perspective on the effectiveness of executive compensation over time. There are two primary alternative views of pay that companies are considering:

  • Realized compensation focuses on the actual value received by executives, comparable to their W-2 income. It includes long-term incentives that are realized, such as restricted stock that vests and the value of exercised options.
  • Realizable compensation assesses the current value of compensation awarded during the time period, whether it has been realized or remains outstanding. Long-term incentives are valued based on the current stock price, with stock options included based on their in-the-money value.

Each methodology has advantages and disadvantages. While actual compensation reflects the committee’s decisions, it does not consider that the value received by the executive will be based on the ultimate value of long-term incentives, which may be driven by stock price and have additional performance hurdles. Realized compensation emphasizes the value actually received by executives, but are influenced by awards granted before the beginning of the performance time period or by timing decisions of the executive, such as the exercise of stock options. Realizable compensation attempts to focus on the value of compensation granted and earned during the performance period, but may require challenging assumptions when long-term performance plans are included.

Reporting Pay for Performance

A key responsibility of the compensation committee, whether public or private, is to test and ensure proper pay-performance alignment annually and over multiple years. The committee should oversee the selection of the peer/reference group, approve the performance measures used in the pay program and analyze how pay (awarded, realized and realizable) aligns with performance over defined periods of time. Graphs and charts can be an effective way to illustrate trends. For example, how has pay tracked against total shareholder return, return on assets and earnings relative to the company’s own internal goals as well as an industry/peer group? Results provide direction as to whether there is alignment between pay and performance or possible deficiencies in the pay program. For example, if a company regularly misses internal budget goals but exceeds peer performance that might indicate stretch goals that may not be achievable. Likewise, if incentive plans are consistently missing thresholds or hitting stretch, that may be an indication of misalignment of goal setting.

While the Dodd-Frank Act required the Securities and Exchange Commission (SEC) to develop rules for companies to disclose the relationship between executive compensation actually paid and financial performance, the SEC has yet to develop proposed rules. However, many companies have started disclosing this in the compensation discussion and analysis of their proxy reports. Likewise, proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis & Co. have their own methodologies for evaluating pay and performance when they develop recommendations for the annual say-on-pay votes required of public companies. For example, ISS looks at the relationship between CEO total compensation and three- year total shareholder return compared to peers and the company’s own five-year total shareholder return. Where their methodology identifies a disconnect, the proxy firms may recommend shareholders vote “against” the pay package. Although it is an advisory vote, it is important for company management and compensation committees to understand the influence of these firms and the potential consequences of a negative vote, which can bring lawsuits and public scrutiny.

Even though the SEC has not yet required a pay-for-performance disclosure, public companies may want to consider whether any disclosure based on the perspectives described above would be useful in their proxies. Whether or not disclosed publicly, all compensation committees should evaluate whether their bank’s programs are creating pay-for-performance disconnects and determine if program changes are needed.

Designing a Win-Win Deferred Compensation Plan

Developing a deferred compensation plan has become popular for many financial institutions. In this video, William Flynt Gallagher of Meyer-Chatfield Compensation Advisors outlines the various types of deferred compensation plans and how to design an effective plan that encourages employee participation while limiting expenses.

Time to Dust Off Those Change-in-Control Agreements

1-3-14-Pearl-Meyer.pngThe best time to address compensation issues related to a potential change in control (CIC) is when you don’t need to: that is, when there’s not an imminent likelihood of being acquired. Too often, CIC provisions that appeared reasonable when written can yield unpleasant surprises for bank shareholders and/or executives in the heat of a potential transaction. From the shareholder perspective, surprises might be significant enough to unwind the deal or lead to unfavorable pricing, while executives may be unpleasantly surprised by net benefits far lower than anticipated, due to automatic cut-backs or excise taxes.

That’s especially true now that we’re in a perfect storm for CIC:

  • Many bank executives during the financial crisis had reductions in compensation in the form of smaller (or zero) incentive payouts and realized value from equity awards. This could result in lower base amounts from which golden parachute excise taxes are calculated (i.e., the individual’s five-year average W-2 earnings);
  • As banks have returned to consistent profitability in the last year or two, they are granting more equity-based awards and bank stock prices are starting to rebound, leading to potentially higher CIC payouts; and
  • merger and acquisition (M&A) activity is heating up in the community bank marketplace.

If your organization has any possibility of being pursued by a potential suitor in the foreseeable future, now would be a good time to review the CIC agreements and related provisions in your equity and supplemental retirement arrangements.

The general rationale behind a CIC agreement is pretty straightforward: to reduce potential management resistance to a transaction that is in shareholders’ best interests. If executives fear losing their jobs (and related future compensation opportunities) as a result of the transaction, they may be more likely to drag their proverbial feet and find reasons not to do the deal. Providing reasonable protection to executives in the form of CIC agreements and related benefit provisions can mitigate this risk. Common benefits promised upon termination following a CIC include cash severance; acceleration of vesting on outstanding equity awards and deferred compensation; and either the continuation of health and other benefits or payment of their cash value.

The unexpected consequences of CIC payments/benefits are mostly attributable to their potentially adverse income tax treatment. Under Internal Revenue Code §280G, punitive excise tax penalties are triggered for the employee and what’s referred to as “excess parachute payments” are not deductible for the company if the present value of all payments related to the CIC totals more than 2.99 times the individual’s base amount. For this reason, most CIC agreements are very clear about how CIC payments will be handled if this limit is exceeded. Historically, CIC payments by the company often included 280G excise tax gross-ups, where the company reimbursed the executive for the taxes owed, to keep the executive whole if the parachute limit was exceeded. As such, the most common bombshells at transactions were the eye-popping, nondeductible gross-up bonuses required to reimburse the executive.

Under extreme pressure from regulators and the investing community, excise tax gross-up provisions at most community and regional banks have been replaced more recently either by a cap on the present value of CIC benefits at the 2.99 limit, or by payout of severance benefits that will result in the most advantageous payout to the executive from an after-tax perspective (often called the best after-tax approach). However, such provisions can create another major challenge—forfeiture by the executive of a large portion of the intended benefits. This is particularly problematic in an environment in which the base amount is already likely to be low given the recent financial crisis.

If addressed far enough in advance of a CIC transaction, banks may be able to make adjustments to CIC provisions to ensure that a much greater portion of the intended benefits is delivered in a tax-efficient manner. At a minimum, reviewing your CIC agreements and performing a few scenario-based calculations can protect against being caught by surprise when a potential deal is in the works.

Don’t wait until a transaction is on your doorstep—dust off those CIC agreements and explore their potential real-life impact now, before it’s too late.