Reconsidering Pay Strategy in the Wake of Inflation

Say goodbye to the Goldilocks economy, where moderate growth and low inflation sustained us for years. Our global economy and social norms have careened from crisis to crisis over the last 24 months. The world has faced down a pandemic, unprecedented restriction of interpersonal interactions, and disruption of worldwide supply chains. And yet the world economy is booming.

Opinions vary about the reality, root cause, and associated solutions for inflation and low unemployment. But what’s critical is that the growing expectation of future inflation is a self-fulfilling prophecy, and that it stresses the systems for retaining and motivating employees.

Inflation simply is another type of disruption, albeit one that impacts companies and employees at nearly every level. Higher input costs lead to lower corporate margins. Higher costs of goods lead to lower individual savings rates (i.e., margins).

People costs are rising, too. Thinking about people cost as in investment allows strategic discussion about maximizing return. The good thing about people investments relative to say, commodity costs, is that cost levers are largely in corporate control and the tradeoffs can be managed. We view it as an imperative to consider changing pay strategy to reflect the reality of a world where the dollar does not go as far.

Companies and boards should think about how well pay strategy addresses four needs:

Need 1: Is our pay/reward strategy about more than dollars and cents?
Employees have far more choices for employment at this time and can command dollars from multiple places and roles. It is worthwhile to think hard about culture — what makes your culture unique, what people value in their roles, and what might be missing — and then build incentives and reward systems that support those activities in balance with financial performance.

Need 2: Does the pay strategy create the right balance of stability and risk?
Adapting pay programs to be more “risk-off” in the face of a highly uncertain external environment may be appropriate. Think about employees as managing to a “total risk” equation. When the expectation was that corporate growth was close to a given, then the risk meter could accommodate taking more risks to earn potentially more money.

Need 3: Are we making the best possible bets on our top talent?
Paradoxically, it might be a time to take more talent risk by digging deep to find your best people and providing them with differentiated rewards, visibility and responsibility. This is the heart of performance management, and it can always improve. The increased risk comes from investing more in fewer people. What if the assessment turns out to be incorrect or if someone leaves? Managing this risk versus avoiding it is the path to success.

Need 4: How are we sure performance in the face of a more volatile outside world is being rewarded?
This is the most “structural” of the needs. Elements to consider would include:

  • Higher merit budgets
  • More modest annual incentive upside and downside
  • Incorporation of relative measurement into incentive programs
  • Rationalization of equity participation and limitations to a smaller group as needed
  • Designation of equity awards based on overall dilution or shares awarded versus dollar amounts

Each of these needs has material tactical considerations that require much discussion about implementing, communicating and managing change. But unlike other major costs, rising people costs present an investment opportunity for increased returns rather than just a hit to the bottom line.

The Revenue Is Not Coming Back: It’s Time to Manage Costs Differently

The revenue’s not coming back: PwC partners John Garvey, Bob Lieberberg & Bob Ross discuss the results of a new study, and why financial firms must focus on expense management to achieve the results they desire.

Related PwC Publication:
PwC Viewpoint: The Revenue is Not Coming Back: It’s Time to Manage Costs Differently

Additional Resources:

Managing Operational Risk is About Managing Your Business Well

7-1-13_Sutherland.pngChinese proverb:  “If we don’t change direction soon, we will end up where we are going”…

The Basel Committee on Bank Supervision, and global regulatory momentum around the Basel Accords catalyzed an operational risk discipline by giving us a formal definition for it: “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” It also created a finite scope for the risk by laying down distinct event categories and descriptions of cause and effect. This meant that operational risk no longer needed to be described in the abstract or in residual terms such as “anything other than credit or market risk” (which, by the way, was never a meaningful statement at all, considering that the administration and management of credit and market risk are themselves fraught with operational risk).

Notwithstanding definitions and regulatory exhortations, operational risk has not evolved as a discipline in the last ten years since the Accords. There has been arguably material progress in measuring it (against losses, scenario and stress analysis, capital postulations), but managing it has been far from easy. Reasons include the fact that it is largely idiosyncratic (in credit and market risk debacles, you tend to sink and swim with everybody else) and asymmetric, since the risk is not passed on to your client and not priced into your products. Operational risk may also be called introspective, as likelihood and severity are both internally determined; and unbounded, as there is no upper limit to potential loss. Traditional belief has been that no portfolio view can be formed, as operational risk is not transactional. You don’t take on the risk or avoid it. It simply exists.

The basic construct of any operational risk program is as follows:

  1. Identify the major risks, as your taxonomy of risks (the Basel event categories should be fine)
  2. Position your internal control environment as a hedge or mitigation for these risks
  3. Through a regime of self-testing, reviews, audits, and risk/control indicators, establish if both the design and effectiveness of your control framework are good and fit for purpose
  4. Ask if your unmitigated risks (and control gaps) are acceptable, and within your appetite for risk

Do all this, and everybody is happy—even the regulator. Do too much, and you have wasted a lot of money, created a big bureaucracy and throttled the business. Do too little, and you have bet your whole business on one big accident.

The real key to managing operational risk lies in recognizing that it simply requires managing the business well, focusing on people, process and infrastructure optimization. This is where the risk-reward consideration, read cost-control, comes into play. A portfolio view of operational risk is in fact available, by looking at the process view of the organization, honing in on what risks arise in pursuing the business, how and where these risks arise in the process sequence, and what mix of people, process and infrastructure could optimally address these.

The implied focus therefore is in the structuring of the end-to-end control framework. This first requires you to clearly define your business objectives, service delivery standards, and compliance requirements. Next, identify the risks that arise in meeting or delivering those objectives, categorizing them along your taxonomy of risks. You can use the Basel framework. Then systematically identify which areas of your activity and processes are directly relevant to those objectives. This allows you to relate your operational risks to the specific processes and activities that carry those risks or are relevant to those risks. Focus then on defining controls where the risks are, specific to the process, in the optimal coverage amount and configuration. Maintain a dashboard of metrics that tell you if your residual (unmitigated) risks are within your risk-appetite and if the controls continue to be designed correctly and working properly. These might include some metrics of well being, similar to vital signs, that indicate business health. A second set of metrics might be smoke-detectors, by business, product, and process, with built-in lights that flash red, yellow, green against specific escalation triggers and trends.

Bottom-line, managing operational risk has never been more important than it is today, but never apparently has it been more conflicted between cost and control. It should not, and does not, need to be so! 

Is Your Compensation Plan Generous Enough?

6-24-13_Equias.pngWhile banks continue to have challenges with low interest rates and slow loan growth, two issues are always critical: (1) the need to attract, retain and reward executive talent and (2) the need to consistently optimize earnings.

Many bankers put compensation and retirement discussions on the back burner for the past four or five years, but are showing a renewed interest in these programs as the crisis has eased. While salary, annual performance bonuses and equity plans are important elements to consider in a compensation plan, many banks have been offering nonqualified plans to help balance the total compensation plan for key executives.

If a bank upgrades its executive compensation and benefits to compete for outstanding talent, won’t the additional cost reduce earnings? Not really. When you are able to attract and retain key officers, the bank can expect to be rewarded with superior performance and increased earnings. Additionally, banks can generally offset these unfunded benefit liabilities with the tax-advantaged earnings from bank-owned life insurance (BOLI).

There are several types of nonqualified benefit plans and unlimited benefit and contribution formulas as well as performance-based strategies that can be incorporated to meet board approval. Where do you begin?

Begin by Understanding Your Shortfall
By design, qualified plans regulated by ERISA (the Employee Retirement Income Security Act) do not provide top executives with sufficient retirement benefits and do not reflect the shareholder value they create. Salary caps, the virtual elimination of defined benefit pension plans and the relatively low level of 401(k) matching contributions typically limit executives’ retirement benefits to 30 to 50 percent of final pay. Knowing the extent of your shortfall (amount needed at retirement compared to estimated amount available) is vital to the design of an effective nonqualified plan.

Regulatory guidance says that the overall compensation package must be reasonable; therefore, SERPs and other nonqualified plans should take into consideration other compensation being provided.

Prevalence of Nonqualified Plans
Such plans are common in the banking industry. According to the American Bankers Association’s 2012 Compensation and Benefits Survey, 68 percent offer some kind of a nonqualified deferred compensation plan for top management (CEO,C-Level, EVP), and 43 percent of respondents offer a SERP.

Nonqualified Plan Basics

  • Supplemental executive retirement plans (SERPs) can be designed to address an executive’s shortfall. Generally, under the terms of a SERP, an institution will promise to pay a future retirement benefit to an executive, separate from any company-sponsored qualified retirement plan.
  • Deferred compensation plans (DCPs) minimize taxation on base salary and bonuses by allowing executives to make elective deferrals into a tax-deferred asset. The bank can also make contributions to the executive’s account using a matching or performance- based methodology.
  • Performance-driven benefit plans tie the bank’s overall objectives to an executive’s measurable performance. As these plans are based on reasonable performance benchmarks critical to the bank’s success, they address corporate governance concerns by increasing compensation only when objectives are met. Part or all of the distributions are made on a deferred basis for a variety of reasons.
  • Split-dollar plans allow the bank and the insured officer to share the benefits of a specific BOLI policy or policies upon the death of the insured. The agreement may state that the benefit terminates at separation from service or it may allow the officer to retain the life insurance benefit after retirement if certain vesting requirements are met.
  • Survivor-income plans/death benefit-only plans specify that the bank will pay a benefit to the officer’s survivor (beneficiary) upon his or her death. Typically, the bank will purchase BOLI to provide death proceeds to the bank as a hedge against the obligation the bank has to the beneficiaries. The benefits are paid directly from the general assets of the bank.

How Banks Use BOLI to Offset the Benefit Expense
The cost of each of the above plans varies by type and design. BOLI is a tax-advantaged asset whereby every $1 of premium equates to $1 of cash value on the bank’s balance sheet. Basically, BOLI is an investment asset that generates a return currently in the range of 3.00 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 4.84 percent to 5.65 percent (assuming a 38 percent tax bracket). From an income statement standpoint, the cash surrender value (CSV) is expected to grow every month. Increases in the CSV are booked as non-interest income on a tax preferred basis. From a cash flow perspective, BOLI is a long-term accrual asset that will return cash flow to the bank upon the death of the respective insured(s).

As an example, let’s assume a 50-year-old executive will be provided a $100,000 per year nonqualified benefit payment for 15 years at age 65. The annual pre-retirement after-tax cost averages $47,000 per year. The bank could invest $2 million into BOLI to fully offset the annual after tax benefit cost.

While bank challenges still remain, providing a balanced and affordable compensation plan that includes nonqualified benefit plans can help make a difference for growing shareholder value.

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