The Compensation Puzzle: Results of the 2013 Compensation Survey

5-17-13_Comp_Research_Report.pngHow should bank boards properly compensate executives, under the watchful eye of regulators and the media, while still retaining key talent? That’s the question with which directors and chief executive officers continue to struggle.  Despite this, there is perhaps a touch of newfound optimism in the banking industry regarding the management and fairness of compensation programs.

Last March, more than 300 directors and senior executives of financial institutions across the U.S. responded to the 2013 Compensation Survey, conducted via email by Bank Director and sponsored by Compensation Advisors by Meyer-Chatfield. Almost half of the respondents were independent directors.  Response was almost evenly split from respondents representing privately-held and publicly-traded institutions.

Key Findings:

  • Bank boards continue to struggle with how to effectively tie compensation to performance.  Sixty-nine percent of respondents cited this as their top compensation challenge for 2013. Boards continue to struggle with regulatory compliance—41 percent indicated that this is a key concern. Rounding out the top three, retaining key people was selected by 40 percent of respondents as a top challenge.  
  • Talent retention could increasingly prove to be a concern for the industry. Forty-four percent of respondents reported the departure of a key executive within the last three years. Very few reported that these departures are due to promotional moves, for a better pay or position, or even lateral moves to other banks. Of those reporting an executive departure, 23 percent indicated that the officer left the banking industry. With increased scrutiny on the industry coupled with the departures of retiring baby boomer executives, could the banking industry find itself in the midst of a talent drain?
  • Thirty-five percent of directors expect to see a pay increase in 2014. Just two percent expect pay to decrease. Moreover, the majority, at 62 percent, believe that they are fairly compensated. Respondents also reported that the amount of time spent on bank board activities remains the same, at a median of 15 hours per month.  
  • The mood is a little lighter. Respondents indicating a positive or neutral feeling in the management of executive compensation rose 17 points from last year’s survey, to 92 percent. When it comes to management of director compensation, those indicating a positive or neutral feeling rose 10 points, to 90 percent.
  • Banks are increasingly tying executive compensation to performance metrics or strategic goals. Still, nearly one-third, or 32 percent of respondents, said they don’t tie executive pay to a strategic plan. 
  • Show me the money. Cash rules as the most valued form of compensation for executives, in the form of salary, and directors, in the form of annual retainer and meeting fees. Benefits for boards, such as retirement or health insurance plans, continue to decline, with 58 percent indicating that they receive no benefits at all as compensation for board service. This represents a drop of 19 percentage points since 2011. 

Download the summary results in PDF format.

Pay Attention: Final Rules on Loan Originator Compensation

4-19-13_Dinsmore.pngJanuary, 2013, was a watershed month for mortgage standards after the Consumer Financial Protection Bureau released the long-awaited final rules on ability to repay, qualified mortgages, mortgage servicing, and appraisal requirements.  Each of these rules promises to keep compliance gurus busy throughout this year and into 2014.

January also heralded another Dodd-Frank final rule of great interest to senior management, boards of directors, and certainly to the frontline, revenue producing, mortgage loan personnel – the mortgage loan originator compensation requirements.

The new compensation rules are potential bottom line changers both for mortgage loan officers/originators and financial institutions themselves—making it imperative that financial institution management and boards of directors move this topic to the top of their to-do lists.

In the aftermath of the mortgage market meltdown, politicians and pundits, and the federal regulators who answer to them, became increasingly focused on the role that loan officers and originators play in the consumer mortgage loan process.  Prior to the meltdown, training and qualification standards for loan originators varied widely within the industry.  Furthermore, compensation programs evolved to incentivize loan officers and originators to lead consumers into more expensive loans.  With Title XIV of the Dodd-Frank Act and the compensation final rules, the consumer protectors set out to end these practices.

What’s Not OK
The rules on compensation prohibit a loan officer/originator from being compensated based on any “term of the transaction” or any proxy for a term of the transaction.  This is not new; this prohibition has been part of Regulation Z since 2011.  The final rule now defines “term of the transaction” but leaves some uncertainty.

A term of the transaction is “any right or obligation of the parties to the credit transaction.”  What does this mean?  The commentary to the final rule answers that question by including descriptions of items the CFPB believes are “terms of the transaction.”  Those items include (see final rule commentary for full list):

  • interest rate
  • prepayment penalty
  • whether a product or service is purchased (e.g., lender’s title policy)
  • fees or charges requiring a good faith estimate and/or HUD-1 disclosure statement (and future Truth-in-Lending Act/Real Estate Settlement Procedures Act combined disclosure)
  • points, discount points
  • document fees; origination fees

What’s OK
CFPB acknowledges the compensation restrictions could create uncertainty for regulated institutions.  To allay this uncertainty, the final rule commentary provides a list of examples of permissible compensation mechanisms, which includes (see final rule commentary for full list):

  • originator’s overall loan volume
  • loan performance over time
  • whether the customer is existing or new
  • quality/condition of loan files
  • percentage of applications resulting in closed loans

Under the final rules, financial institutions are permitted to continue paying mortgage loan officers/originators bonus compensation.  However, bonuses will be subject to some restrictions.  Bonuses may not be based on the terms of the individual loan officer/originator’s transactions, and bonus compensation cannot exceed 10 percent of the individual loan officer/originator’s total compensation for the relevant period.

Looking Forward: Best Practices
The new compensation rules and the other residential mortgage related rules go into effect in January, 2014. Examination teams, armed with new exam procedures, will be descending on banks to test for compliance.  Below are a few best practice steps bank managers and boards of directors may take to be prepared.

  1. Ensure consumer compliance teams are trained on the new rules.  Modify consumer compliance audit/review procedures to ensure new rules are appropriately tested.
  2. Ensure mortgage lending management teams and loan officers/originators are trained on the new rules.
  3. Review existing loan officer/originator compensation programs, policies and practices to determine level of compliance; adjust programs and practices accordingly.
  4. Review existing employment, service, and management agreements and other documents relating to residential mortgage lending to determine if problematic provisions exist; amend agreements as necessary.
  5. Assign appropriate personnel to monitor release of guidance from CFPB and other federal regulatory agencies; review new examination procedures when available.
  6. Have management report to board of directors, or appropriate committee, on progress toward compliance.

There is Still More
The compensation final rules address several other important topics, including dual compensation, payment of upfront points/fees, loan originator qualifications, and mandatory arbitration provisions.  These topics are important for all participants in the mortgage lending arena, and you are encouraged to review them.

Three Questions to Pull Back the Curtain on Discretionary Pay

3-19-13_Semler.pngJudgment by directors acting on shareholders’ behalf is a cornerstone of U.S. corporate governance. So why is it so controversial when CEO pay is based on judgment? 

This post focuses on a more structured approach to making and explaining discretionary pay decisions. It’s not a post about the say-on-pay shareholder advisory vote, which is now required for publicly traded firms, but we use it as an illustration because it has brought the issue to the fore in many boardrooms. A more transparent process, with clear expectations and discussions, can focus performance messages and de-mystify the pay decision for all employees in addition to informing shareholders publicly about CEO pay.  

Many of our financial services clients use discretionary approaches to deliver pay and performance messages. The virtue of this model is that it allows for a multi-faceted evaluation of corporate and individual performance. A strict formula does not necessarily create a holistic view of results delivered, no matter how complex or long-term the system.  

Say-on-pay has increased the external focus on understanding the relationship between senior executive (primarily CEO) pay and performance. The compensation discussion and analysis section of the proxy form is intended to provide shareholders with insight into the material elements of the pay decisions. Shareholders often rely on proxy advisors, whose recommendations can be highly critical when their simple analyses indicate a pay and performance “disconnect.” If the proxy does not provide enough insight, shareholders must come to their own conclusions about pay and performance.

A compensation committee may interpret this as a demand for a rigid formula by an outsider that “doesn’t get it.” Critiquing proxy advisors is a path well-worn. We’re taking a different tack, with greater potential benefit. Criticism of discretionary pay should prompt a committee to investigate the process and communications to ensure that shareholders and those getting paid have a clear understanding of performance and dollars earned.

Committees should start with three questions:

1. Do executives (and shareholders) know what results we value?
These vary. Financials and shareholder return over time are always important, but how results are achieved also must be reflected in the assessment. These can be environmental (e.g., good performance in a down cycle), or internally-focused (e.g., exceeding numbers in a business at the expense of companywide performance). These are often more nuanced and can be more critical to future success than just “making plan.” Of course, pay has to be affordable, but there’s value in investing in pay to encourage non-financial activity that creates future success. If you’re not clear about what results are important and how to achieve them, how can executives (shareholders) understand pay decisions?

2. Do executives (and shareholders) understand performance assessments?
This approach is formal, not formulaic, and has key questions of its own:

  • Are there individual performance discussions up front and throughout the year about key accountabilities? 
  • Does the compensation committee hear from the CEO and executives about results and individual performance? 
  • Are questions asked to fully understand successes and areas of development?
  • Are goals measurable and tied directly to financial, operational and strategic priorities?

There should be no pre-established weightings, allowing decisions to focus on what was really important, compensate executives accordingly and provide a clear rationale for pay decisions. If you aren’t talking about expectations and progress, how can you be clear about performance on the most important items?

3. Do executives (shareholders) get a clear explanation of the pay decision?  
A chief financial officer once told me that 90 percent of his time delivering pay decisions is spent with the lower performers, who tend to argue about their performance assessment and lobby for more money. A high-performing executive at the same bank told me, “Pay discussions last two minutes. They tell me my number and I say ‘thanks’.” This is a model working in reverse. The year-end discussion should be a proactive, rich overview of expectations, performance and next challenges. Arguably the most time should be spent with future leaders versus poor performers, and the conversation should be driven by the person delivering rather than receiving the message. If you don’t use the pay discussion wisely, how will your top performers be energized to continue to succeed? 

Fully discretionary pay is very powerful, but to quote from Uncle Ben in the Spider-Man comics, “with great power comes great responsibility.” Proxy advisor criticism in say-on-pay recommendations may seem like an obtrusion by uninformed third parties. We think there’s an alternative viewpoint. Before you dismiss or rail against your critics, ask three questions to ensure you’re getting everything you can from how you make and communicate pay decisions. 

Why It’s Important to Calculate Your Change-In-Control Payouts Now

iStock_000019351044XSmall.jpgBusiness planning is a key bank responsibility, but many institutions fail to adequately address a critical element of planning:  clarifying and understanding the impact of severance and change-in-control benefits in the event of a potential future transaction.  

Deal offers are often unexpected or need to be quickly evaluated. Negotiations go much more smoothly if the bank has already defined and detailed its change-in-control (CIC) terms and fully considered their potential impact on the executive team.  Why? 

Consider this scenario.  Let’s say the bank’s board and management have agreed on fairly standard and, they believed, fair CIC severance packages:  two times base salary + bonus along with equity acceleration and benefits continuation.  In the process of setting terms, however, the bank made what is actually a common error: It failed to consider the potentially significant impact of the golden parachute excise tax.  

When the bank did the tax calculations, it discovered executives would be subject to an excise tax that would reduce their net severance payout by more than half. Only when the deal became real did it become clear that the benefit structure and ultimate payout would be significantly different than what was intended.   

This unplanned outcome forces two negotiations.  First, the target’s management and board will try to resolve the difference between the intended and the actual value.  But with an offer already on the table, there will need to be a second negotiation with the buyer to get agreement on any changes to the terms.  As a result, the target and the buyer are distracted from the primary objective, which is to evaluate and approve a deal that will create value for both banks’ shareholders.

I will be discussing this and other topics impacting mergers and acquisitions at the Bank Director Acquire or Be Acquired conference in Scottsdale, Arizona, Jan. 27 to Jan 29, including the following: 

  • What are banks doing about CIC benefits?
  • What are some of the “hidden” negative consequences?
  • What can banks do to help mitigate these unintended consequences?