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

What’s Changed in Executive Compensation Since the Crisis

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compensation-3-4-19.pngA decade ago we were in the middle of an economic downturn and the world of executive compensation was under intense scrutiny.

One target for that scrutiny was executive benefits and perquisites. Things like excessive change-in-control payouts with “gross-ups” and perquisites like vehicle allowances and country club memberships were placed under the microscope.

Executive perquisite policies were put in place, and additional focus was placed on the SEC proxy statement disclosures of perquisites in the Summary Compensation Table when the aggregate amount exceeds $10,000.

To track the impact of these changes, Blanchard Consulting Group has conducted a benefits and perquisites survey three times over the last 10-year period. The most recent survey was completed in early 2019.

Here are three key areas:

Change-In-Control Agreements & Gross-Ups
The prevalence of CIC agreements has been consistently between 50 and 60 percent each time we have conducted our survey, so there has really been no change in the market surrounding who has these provisions in place. For additional reference, our public bank database indicates this segment is slightly above 80 percent prevalence for CIC agreements and this hasn’t changed much either in recent years.

What about severance multiples paid? Consistently, the most common response (around 35 percent) is the multiple for CEOs has been between 2 and 2.5 times salary or cash compensation.

So how about the “gross-up” clauses that added pay to the executive severance package if their payout was deemed excessive for Section 280G of the tax code? Our research only shows a slight decrease in the prevalence of these clauses. About 25 percent of the sample indicated they had them when we first conducted the survey and now we are just below 20 percent of the sample.

In summary, not much has changed surrounding CIC agreements and “gross-up” clauses.

Supplemental Retirement Plans
The existence of supplemental executive retirement plans (SERPs) or salary continuation agreements (SCPs) have declined from 53 percent in 2011 to 47 percent in 2018, which is not a lot of movement. Prevalence of these plans at public banks has hovered around 45 percent.

What about the benefit amounts being paid under these plans? Not much has changed here either. Around 70 percent of CEOs with defined benefit amounts are targeting something below 55 percent of final compensation, which is the same in 2018 versus 2011.

Supplemental retirement plans have not experienced much change in the banking market either.

Perquisites
Executive perquisites have not changed much surrounding car allowances or country club, hovering around 70 percent prevalence. This is very similar to the numbers back in 2011. In fact, the percentage of banks who do not offer any perquisites to their executives has only dropped a couple of percentage points, from 12 percent to 8 percent.

So once again, not much has really shifted or changed in the world of executive perquisites either.

Summary
So what should we make of the fact that there appears to be no significant adjustment, “scale-down,” or elimination of executive benefits and perquisites in the last 10 years? Did regional and community banks simply ignore the government-focused initiatives?

Some might say yes, but there’s another argument to be made.

It’s possible that community and regional banks were simply never paying their executives inappropriately or excessively. The compensation designs in place at those institutions were market-based, competitive, and reasonable. During the downturn many executives experienced salary freezes and either zero or minimal cash bonuses as bank performance dropped.

This was appropriate under pay-for-performance incentive plan designs. Since that time, compensation has increased as bank performance has increased and not much has changed in the world of executive benefits and perquisites.

These benefits and perquisites were reasonable then and are still reasonable now in the eyes of the decision-makers at community and regional banks.

Compensation Plans Should Be As Strategic As They Are Attractive

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strategy-10-30-18.pngHuman capital is likely the most expensive resource a bank has, and we all know our people are important in a customer-facing business, so why not be strategic with it? Almost every business has a written strategic plan that states profitability goals, growth goals, three-year plans, etc. However, when it comes to compensation, fewer than four in 10 banks (38 percent of the 103 banks surveyed in our 2016 Compensation Trends Survey) have a formal, written compensation philosophy.

The Compensation Philosophy
Most organizations start the strategic compensation discussion with the development of a compensation philosophy. This document, often only a page or two, primarily identifies a few key items, including what the bank is trying to accomplish with its compensation programs; what compensation programs does the bank have available to our employees; who qualifies for these programs and why; and where does the bank want to position ourselves versus market? The compensation philosophy statement should be a living document that is reviewed annually and is adjusted as necessary to support business strategy changes.

Strategic Salary Planning
Banks that are strategic with compensation will also generally have a clearly defined salary grade structure, accurate and up-to-date job descriptions, utilize external market data for position benchmarking, and a salary increase matrix for annual adjustments. The annual salary increase process should be strategic, based on individual performance, foster internal equity, and fit within the overall budget of the organization. Many banks utilize a salary increase matrix to assist with determining annual raises. The matrix focuses on providing the largest increases to employees who are exceeding expectations and are positioned low in their salary grade. The days of giving everyone the same percent of salary raise are gone.

Performance-Based Incentives
Once you have the salary component figured out, the next step is incentive-based pay. This can take the form of annual cash incentives and/or equity-based incentives. The type of incentive a bank utilizes will often vary depending on the company structure—like whether it is public or private—and position level. As an example, executives may be eligible for a cash and equity incentive plan, but staff may only be eligible for cash incentives. The key to using strategic compensation is to make sure your incentive plans are based on performance and are motivating and rewarding key positions.

In today’s banking world, there is a lot of talk about incentive plans being “risky” and maybe even “evil” (example: Wells Fargo retail incentives). We disagree with this sentiment. Banks are still in the business of being profitable, and incentive plans have their place to help drive behaviors and reward performance. The key is to have a balanced approach between profitability and strategic goals.

Benefits and Perquisites
Benefits and perquisites are total compensation components that often apply primarily to executives. The broad-based benefit programs like 401(k) plans and health insurance programs have not experienced unique banking-focused changes in recent years. However, executive benefits such as salary continuation plans, change-in-control/severance plans, employment agreements and perquisites (auto allowances, country clubs, etc.) have seen reductions. These programs are still prevalent but there has been an increased focus on the business reasoning and validation behind such programs.

Executive benefits can provide some of the best retention vehicles in compensation if you have an executive leadership team you want to keep in place long-term. It is critical to ensure the benefit or perquisite is serving an appropriate business purpose.

The most successful banks are those who can appropriately balance their profitability needs with good culture, communication, and strategic compensation programs. Banks need to be financially successful to help the communities they serve. Ensuring that your compensation programs are strategically supporting the overall goals of your organization and linked to performance is essential. Make sure you are getting your “bang for the buck” with your compensation dollars being spent.