Lessons in Deferred Compensation

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

Banker’s Perspectives

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

Consultant’s Perspective

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

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

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

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

Use Compensation Plans to Tackle a Talent Shortage

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Can you believe it’s been 10 years since the global financial crisis? As you’ll no doubt recall, what was originally a localized mortgage crisis spiraled into a full-blown liquidity crisis and economic recession. As a result, Congress passed unprecedented regulatory reform, largely in the form of the Dodd-Frank Act, the impact of which is still being felt today.

Significant executive compensation and corporate governance regulatory requirements now require the full attention of senior management and directors. At the same time, shareholders continue to apply pressure on management to deliver strong financial performance. These challenges often seem overwhelming, while the industry also faces a shortage of the talent needed to deliver higher performance. As members of the Baby Boomer generation retire over the coming years, banks are challenged to fill key positions.

Today, many banks are just trading people, particularly among lenders with sizable portfolios. Many would argue the war for talent is more intense than ever. According to Bank Director’s 2017 Compensation Survey, retaining key talent is a top concern.

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To address this challenge, many banks have expanded their compensation program to include nonqualified benefit plans as well as link a significant portion of total compensation to the achievement of the bank’s strategic goals. Boards are focusing more on strategy, and providing incentives to satisfy both the bank’s year-to-year budget and its long-term strategic plan.

For example, if the strategic plan indicates an expectation that the bank will significantly increase its market share over a three-year period, compared to competition, then executive compensation should be based in part upon achieving that goal.

Achieving Strategic Goals
There are other compensation programs available to help a bank retain talented employees.

According to Federal Deposit Insurance Corp. call report data and internal company research, nonqualified plans, such as supplemental executive retirement plans (SERPs) and deferred compensation plans, are widely used and are particularly important in community banks, where equity or equity-related plans such as stock options, restricted stock, phantom stock and stock appreciation plans are typically not used. These plans can enhance retirement benefits, and can be powerful tools to attract and retain key employees. “Forfeiture” provisions (also called “golden handcuffs”) encourage employees to stay with their present bank instead of leaving to work for a competitor.

SERPs
SERPs can restore benefits lost under qualified plans because of Internal Revenue Code limits. Regulatory rules restrict the amount that can be contributed to tax-deferred plans, like a 401(k). A common rule of thumb is that retirees will need 70 to 80 percent of their final pre-retirement income to maintain their standard of living during retirement. Highly compensated employees may only be able to replace 30 to 50 percent of their salary with qualified plans, creating a retirement income gap.

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To offset this gap, banks often pay annual benefits for 10 to 20 years after the individual retires, with 15 years being the most common. SERPs can have lengthy vesting schedules, particularly where the bank wishes to reinforce retention of executive talent.

Deferred Compensation Plans
We have also seen an increasing number of banks implement performance-based deferred compensation plans in lieu of stock plans. Defined as either a specific dollar amount or percentage of salary, bank contributions may be based on the achievement of measurable results such as loan growth, increased profitability and reduced problem assets. Typically, the annual contributions vest over 3 to 5 years, but could be longer.

While deferred compensation plans have historically been linked to retirement benefits, we see younger officers are often finding more value in cash distributions that occur before retirement age.

To attract and retain millennials in particular, more employers are expanding their benefit programs by offering a resource to help employees pay off their student loans. According to a survey commissioned by the communications firm Padilla, more than 63 percent of millennials have $10,000 or more in student debt. Deferred compensation plans can also be extended to millennials to help pay for a child’s college tuition or purchase a home. Because these shorter-term deferred compensation plans do not pay out if the officer leaves the bank, it provides a strong incentive for the officer to stay longer term.

Banks must compete with all types of organizations for talent, and future success depends on their ability to attract and retain key executives. The use of nonqualified plans, when properly chosen and correctly designed, can make a major impact on enhancing long-term shareholder value.

Insurance services provided by Equias Alliance, LLC, a subsidiary of NFP Corp. (NFP). Services offered through Kestra Investment Services, LLC (Kestra IS), member of FINRA/SIPC. Kestra IS is not affiliated with Equias Alliance, LLC or NFP.

What Are the Best Ways to Fund Your Retirement Plans for Executives and Directors?

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retirement-plan-4-20-16.pngNonqualified deferred compensation (NQDC) plans continue to be important tools to help banks attract, reward and retain top talent in key leadership positions. In order to retain their critical tax deferral benefits, such plans must remain unfunded. For tax purposes, a plan is “funded” when assets have been unconditionally and irrevocably transferred for the sole benefit of plan participants. Formal funding of qualified plans, such as a 401(k), does not subject the participants to immediate taxation—participants can defer taxes until they actually receive such income. However, qualified plans have limitations on the level of benefits that can be provided and these limits can lead to substantial shortfalls in expected retirement income for executives and other highly compensated persons. NQDC plans came about specifically to help offset those shortfalls.

The restrictions on funding NQDC plans leads plan sponsors to search for solutions to finance or economically offset the costs of providing enhanced benefits to NQDC plan participants. When you hear someone refer to “funding a NQDC plan,” this is what they mean. Economic, or informal, funding means that the bank acquires and owns the particular asset of that funding method and that at all times such assets are subject to the claims of the bank’s creditors. Our objective for this article is to review and compare the financial statement impact of various methods for economically funding such plans. In our examples we use a Supplemental Executive Retirement Plan (SERP) and the following funding methods: 1) unfunded; 2) bank-owned annuity contract; 3) bank-owned life insurance (BOLI); 4) a 30-year, A-rated corporate bond; and 5) a 30-year, bank-qualified municipal bond. The same investment allocation and same cost of money were used in scenarios two through five.

  1. Unfunded
    A benefit plan is implemented and no specific assets are earmarked to generate income to offset the expenses. The bank accrues an accounting reserve for the benefit liability as required under GAAP and makes payments out of general cash flows. This method is simple and has often been used when the bank does not have additional BOLI capacity.
  2. Bank-Owned Annuity Contract
    The bank purchases a fixed annuity contract (variable annuities are not a permissible purchase for banks) on the lives of the plan participants. While the primary advantage of purchasing an annuity is that the cash inflows from annuity payments can be set to match the cash outflows for benefit payments, because corporate-owned annuities do not enjoy the tax deferral benefits of individually owned annuities, there is a mismatch of income taxation (annuity) with income tax deductions (benefit payments). Fixed annuity contracts with a guaranteed lifetime withdrawal benefit provide a specified annual payment amount commencing when the executive reaches a certain age (usually tied to retirement). Payments are made for the life of the annuitant. Fixed annuity contracts generally do not respond to movements in interest rates.
  3. Bank-Owned Life Insurance (BOLI)
    The bank purchases institutionally priced life insurance policies on eligible insureds to generate tax-effective, non-interest income to offset and recover the cost of the benefit plan. When properly structured and held to maturity, earnings on BOLI policies remain tax-free, eliminating the tax mismatch issue. The tax-free nature of BOLI earnings often allows the bank to exceed the yields on taxable investments on a tax-equivalent basis. Top BOLI carriers structure their products so that they do respond to market rate movements, albeit on a lagging basis.
  4. 30-Year, A-Rated Corporate Bond
    A 30-year, A-rated corporate bond is a simple and transparent investment vehicle. Because investment earnings are taxable as earned, and benefit payments are not deductible until paid, the tax mismatch is the primary disadvantage. Corporate bonds do respond to market rate movements, leading to potential volatility in market values.
  5. 30-Year, Bank-Qualified Municipal Bond
    A 30-year, bank-qualified municipal bond is similar to a 30-year corporate bond except the earnings are tax free.

In summary, key to the funding analysis is evaluating the best investment for the bank that will mitigate the impact of the plan expenses and liabilities on the bank’s financial statements with bank-eligible investments. The following table summarizes the projected net financial statement impact of the five methods discussed above in both today’s interest rate environment as well as the projected impact in a rising rate environment. As you can see, BOLI and a 30-year bank-qualified municipal bond offer some of the better ways of funding the plan over time.

Funding Your NonQualifed Deferred Compensation Plan

  Projected Life of Plan Net Income(Expense)*
Method of Funding Today’s Rate Environment Rising Rate Environment
Unfunded $(772,439) $(772,439)
Bank-Owned Annuity Contract $(164,229) $(439,597)
Bank-Owned Life Insurance (BOLI) $190,369 $1,598,371
30-Year A Rated Corporate Bond $(114,989) $(235,872)
30-Year Bank-Qualified Municipal Bond $221,007 $701,441

*Based on $500,000 single premium investment. Current rates are as of March 2016. For more detailed information as well as the relevant assumptions used, please contact David Shoemaker at [email protected] or 901-754-4924.

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

Designing a Win-Win Deferred Compensation Plan

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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.