In the wake of the financial crisis, all the big banks had to change executive compensation plans to reduce risks. Regulators are keeping a close eye on these plans and sometimes requiring a mountain of paperwork to document them. Here, Scott Law, the executive vice president and director of compensation at $58 billion asset Zions Bancorporation, talks about how the changes have impacted his company.
Creating 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.
Taking tests would certainly be easier if you had the answers beforehand. What if you also had the ability to determine those answers? Well, that is exactly what compensation committees and bank executives should be thinking when they develop a written compensation philosophy. Put in the effort up front, so when the tough decisions have to be made, you already have the answer key developed. A well thought out and well documented compensation philosophy makes life easier. So where do you start?
If you don’t have a written compensation philosophy, I suggest you start discussions with the compensation committee and the CEO (add other key executives if appropriate) to get the ball rolling. Talk about the organization’s beliefs surrounding compensation and how you want to strategically position your compensation programs to help achieve your goals. And remember, there is no right or wrong compensation philosophy. You get to decide your unique answer.
Focus on Total Compensation
The philosophy should focus on the total compensation package. That means base salaries, incentives (cash and equity if available), benefits and perquisites. It should cover what programs you have, who qualifies for those programs, and where you want to be positioned compared to market. Ask yourself some critical questions, such as:
What are we trying to accomplish with our compensation programs?
Do we believe in pay for performance?
Should certain employee levels qualify for certain compensation programs?
Where do we want to be positioned compared to market?
What can we afford? (Don’t forget this one.)
These questions will help get you started down the road that is right for you.
Put it on Paper
Once you have determined the answers to some key questions you can start to draft a philosophy statement. Be sure you cover all compensation components from a high level and discuss how they fit into the complete picture. For example, if you start with base salaries and think they should be positioned at market competitive levels for fully functioning employees, then you need to take the next step and determine your market and your job expectations. Often, specific percentile positions (i.e. 50th percentile) will be mentioned in philosophies and other times ranges may be utilized. Be as specific as possible (at least internally). Some organizations will choose to lead or lag the market for specific purposes. As an example, a very performance-driven company may choose to slightly lag the market on salary, but provide high incentive opportunities based on performance that would allow the employees to potentially earn a total compensation package that is above market. This will likely attract a certain type of employee and should be communicated at the time of recruitment.
Test Your Philosophy vs. Current Reality
Once you have drafted your philosophy, you should test your goals against reality. Start by asking yourself: Are we currently practicing what we just wrote down? Or will this require a cultural shift? Some organizations incorporate a reality philosophy and an aspiring philosophy. For example, maybe you want to target salaries between the 50th and 60th percentiles of the market, but you realize you are currently paying closer to the 40th. You can’t afford to make huge adjustments all at once, so you develop a plan to get there during a period of time. This has been very common in recent years where performance challenges in the banking industry created the need for a re-set button for a lot of compensation philosophies.
Communicate Your Philosophy
Once you feel you have developed a philosophy that works for your organization, you need to communicate this philosophy. Your human resources department and managers will be critical in helping with this phase. Every employee should understand your compensation philosophy and where their specific position fits. For example, if you have determined that certain levels of employees (i.e. senior vice presidents and above) qualify for participation in a long-term incentive plan, then use this as a motivator and performance driver for those employees at the vice president level or below to aspire to that level and be rewarded for that achievement.
Put it Into Practice, Revisit and Revise
Once the philosophy is developed, written, tested and communicated, you need to keep it current and use it to make life easier. Those making decisions around hiring, annual salary increases, incentive program payouts and executive benefits should annually go back to the compensation philosophy and be sure their decisions are consistent with the stated philosophy. Each year, the compensation committee, CEO, and human resources department should review the philosophy and determine if externally or internally things have changed significantly enough to require a strategic change. It is OK to revise the philosophy for strategic purposes from time to time, but it should generally be looked at as a document of guiding principles that provides more answers than questions.
Tying compensation to performance is the top compensation challenge for bank boards, according to a survey of more than 300 bank directors and executives conducted by Bank Director in March. Some banks are approaching this challenge in unique ways. Bank Director asked upcoming speakers at its Bank Executive & Board Compensation Conference in Chicago Nov. 4-5 to share the most innovative compensation package they have seen.
What’s the most innovative CEO or employee compensation package you have seen?
A privately-held bank was seeking to reduce its use of equity awards while maintaining a program that motivated executives and aligned their compensation with shareholder returns. The company replaced some equity grants with a new long-term cash plan tied to three-year return-on-equity goals, which reduced the equity grant rate while retaining alignment with the return provided to shareholders. The company continued to grant stock options, including some with a premium exercise price, to reinforce the link to value creation for shareholders. The long-term program also includes potential reductions in payouts if performance on credit and risk measures fails to meet expectations during the vesting period. While this program may not be appropriate for many banks, for this bank it aligned with their business objectives while maintaining a balance between risk and reward.
—Daniel Rodda, lead consultant, Meridian Compensation Partners, LLC
It’s not a bank, but the most interesting one I have seen is for the chairman and CEO of GAMCO Investors. He does not receive salary, bonuses, or stock options, but is paid a management fee of $69 million.
—Dennis Gustafson, senior vice president and financial institutions practice leader, AHT Insurance
A large financial institution wanted solutions to unintended consequences surrounding officer compensation plans. The bank annually awarded significant equity grants to all officers in the form of options or restricted shares. A deferred compensation plan also allowed officers to defer a portion of salary, annual incentive and/or equity grants in various funds, with disbursements made in company stock upon retirement. The bank officers were concerned regarding the concentration of compensation in the form of bank stock and the lack of diversification upon distribution from the deferred plan. We swapped existing equity grants in a value-for-value exchange for cash-settled restricted stock units, which were then deferred into a new fund using our patent-pending LINQS+TM design. The end result was a significantly reduced shareholder dilution, diversification for the officers, and a lifetime retirement benefit.
A bank I know focused its CEO pay on the success of its business strategy (driving profitable, risk- appropriate growth through acquisition). Base salary and annual cash incentives were minimized with stock based compensation representing the majority of his compensation. A modest portion of the grant consisted of restricted stock that would cliff vest after three years to provide retention and ownership perspective. The majority of shares would vest only if a balanced scorecard of measures were achieved (profitability, shareholder return, efficiency and asset quality). This encouraged the CEO to focus on long rather than short-term results. Ownership and holding policies, along with the CEO purchasing shares outside the program illustrated his “skin in the game” and alignment with shareholders. The business plan was exceeded, share value increased and the CEO was rewarded accordingly.
—Susan O’Donnell, lead consultant, Meridian Compensation Partners LLC
Pearl Meyer & Partners worked with a compensation committee that, on the heels of the financial crisis, needed a more rigorous set of annual incentive goals. The committee members elected to remove some of the usual guess work in establishing annual incentive plan goals by taking a new approach to the concept of plan funding triggers. Rather than the common approach of using a single earnings-based trigger to determine whether the entire plan gets funded, they revised their plan to include “gatekeepers” based on performance relative to a peer group for each of the plan’s four corporate financial goals. Meeting the gatekeeper for a specific metric would then trigger a potential incentive payout if the bank also meets its budgeted goal for that metric. This approach promotes a more balanced assessment of performance relative to peers as well as to the bank’s budget. The result: a higher level of confidence by directors and investors that pay will be directly aligned with performance.
—Greg Swanson, vice president, Pearl Meyer & Partners
The three-year average total shareholder return of the KBW Regional Banking Index was greater than 13 percent as of June 30, 2013. Banking stocks are recovering, creating renewed interest in programs that reward executives appropriately for continued growth in share price and dividend yield.
Options provide the most direct reward for creating shareholder value. If the stock price goes up, executives and shareholders alike share in the upside. The counter argument is that options are far too subject to market whims and since an executive receives more “return” with options as the stock price increases, this could motivate the very behaviors that started the financial crisis.
Restricted stock may seem like a safer alternative, but without some type of performance element, the awards may just serve as an incentive for executives to stay put, at least until their awards vest.
In this environment, how do directors design equity awards that will provide a meaningful link back to shareholder value?
There are five questions that directors can ask to gain clarity and create an effective equity grant strategy:
1.Who should receive an award?
There is often a consensus that senior management should receive equity as a normal part of the pay program. The subject of debate is typically who should receive awards below that level. Competitive practice, dilution and financial impact all play a role in determining how deep equity awards are granted within a bank. In our experience, the answer truly depends on the culture of the organization and what messages the bank wants to send regarding the behaviors that are most valued. If individual performance is important, defining and rewarding a pool of top performers can be highly effective. If revenue production is king, granting equity to top producers in areas such as commercial lending may aid in the retention of key rainmakers.
2.Is the goal of granting equity awards to reward performance or to retain executive talent?
In a recent survey conducted by Pearl Meyer & Partners, reward and retention tied at 89 percent as the top long-term incentive objectives for banks. Such multiple strategic objectives may call for granting both time- and performance-based awards. For example, a bank may decide to grant part of the award in time-vested restricted stock that is subject to holding requirements and provide the remainder as performance-based restricted stock.
3.Should performance-based awards strictly reward total shareholder return or operational performance that may result in a higher stock price?
In the same survey, nearly 70 percent of banks said they evaluate their long-term incentive programs on the basis of positive operational performance, versus 42.7 percent who focus on gains in total shareholder return. Members of management who believe that vagaries in the stock market are not under their control generally would prefer measures that correlate to increased shareholder value such as earnings per share, tangible book value, return on assets and return on equity as the key metrics for granting stock or vesting stock.
4.Once an award is exercised or vested, what is the executive’s obligation?
One of the primary reasons for granting equity awards is to promote executive stock ownership, since tying a significant portion of an executive’s wealth to share price puts that executive on the same side as shareholders. The counterargument, however, is that long-term incentives are just that—incentives—and if performance is achieved, the executive should be able to reap the reward. Defining retention requirements and/or ownership requirements upfront can address these issues by establishing reasonable expectations around the executive’s obligation and what may be received as a reward.
5.How do we handle competing goals in our equity grant strategy?
Often, bank boards and management teams want to achieve multiple goals in their equity strategy. Being deliberate in the mix of equity types, the selection of eligible employees and the achievable retention/ownership guidelines will provide a balanced approach.