Three Reasons Why You Should Care About the New Proposed Incentive Compensation Rules

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compensation-7-4-16.pngOne of the dangers of the snail-paced rulemaking under certain sections of the Dodd-Frank Act (DFA) is that we all get lulled to sleep and simply yawn when another set of proposed rules surfaces—especially when five years elapse between proposals. But here we are. Another round of proposed rules under DFA Section 956 was jointly released by six regulatory agencies in April and is intended to establish incentive compensation rules for financial institutions with assets greater than $1 billion.

Here are three reasons why you should care.

Reason #1: These will be rules—not guidance.
The underlying intent of the proposed rules should be familiar to banks and thrifts, as the foundation for the rulemaking is taken directly from the interagency Guidance on Sound Incentive Compensation Policies (SICP Guidance) which has applied to all banks and thrifts since June 2010. However, not all institutions have made a serious effort to comply with the spirit of the SICP Guidance and bank regulators have been somewhat lax in this area for community and regional institutions unless there have been problems in other areas of the bank. But under the pending rules, covered institutions will be required to create and maintain records for a minimum period of seven years, demonstrating compliance with the rule. Presumably, that means noncompliance in any given year could be challenged by regulators during an examination conducted up to seven years later, heightening the importance of ensuring compliance from the very first year the rules are in effect (as early as 2019). We encourage covered institutions to use this interim time in advance of the final rules to reevaluate policies, procedures and documentation related to incentive compensation risk management to determine if they are prepared for compliance.

Reason #2: There are certain plan features you must include.
A more prescriptive tone is being set by this round of the proposed rules, with three “musts” outlined for incentive arrangements at all covered institutions:

  • Must include both financial and non-financial measures;
  • Must allow non-financial measures to override financial measures, if appropriate; and
  • Must provide for downward adjustments to reflect actual losses, certain risk-taking, compliance deficiencies, and other measures or aspects of performance.

The concept of non-financial performance measures in incentive arrangements is not new for banks. But a regulator’s definition of “non-financial” almost certainly is focused on safety and soundness, and not necessarily on business or leadership strategy. Start thinking about how your incentive arrangements will address the “musts,” particularly related to the ways in which risk-oriented non-financial performance measures might be incorporated in a way that doesn’t diminish the incentive plan’s effectiveness.

Reason #3: You may need to punch above your weight class.
Sure, the most rigorous requirements under the proposed rules appear to be focused on institutions with assets over $50 billion. But don’t take too much comfort in being under $50 billion in assets, or under $1 billion, for that matter. The proposed rules explicitly provide for the relevant agency to treat a covered institution with $10 billion in assets as though it’s the one of the big guys if it deems the institution warrants such treatment. And since there are explicit provisions for ignoring the size of an organization under the rules, trickle-down regulatory expectations will inevitably reach institutions not technically covered under the rules, even if only through deeper review of compliance with the SICP Guidance. Our advice: err toward complying with the requirements of the next level up.

Given this is round two of the proposed rules, the final rules will likely be very similar to the April proposal. So, if we caught you yawning, we encourage you to wake up, grab a cup of coffee, and take some productive steps. Now is the time for action, so you can rest assured your institution will be ready.

Do You Have the Right Incentive Goals?

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The first quarter of every fiscal year finds compensation committees and management teams wrestling with setting performance goals for the coming year’s incentive arrangements. What does that process look like for your institution?  If your company hasn’t conducted a ground-up assessment of the goal setting process in recent years, consider taking a fresh look at your approach this year.

How does your institution select the performance measures?
In Pearl Meyer’s recent survey, Looking Ahead to Executive Pay Practices in 2016 – Banking Edition, respondents indicated the following three factors as having the greatest influence on performance measure selection:

We would argue that the “long-range or strategic plan” should carry substantially more influence in the selection of performance measures than the other two factors–doing so also takes substantially more effort and intentionality. In contrast to plucking some high profile measures from the approved budget, copying what peers are doing, or appeasing institutional investors or their advisors, selecting measures that effectively support the long-range or strategic plan requires a multi-step line of thinking that starts with the end goal in mind (long-term growth in enterprise value) and drills down to very specific actions that need to occur now in order to achieve the end goal.

Some practical steps in the process include the following:

  • Outline the company’s business objectives and strategy and the drivers of long-term value creation. Then select short- and long-term incentive performance measures that directly tie to the achievement of milestones toward these goals.
  • Identify and focus on the centerpiece financial metrics that will signal success within your company, your industry and the global economic environment.
  • Incorporate both “lag” metrics (that reward achievement) and “lead” metrics (that spur desired new actions and behaviors).

Once the measures are selected, how does your institution set performance expectations?
Respondents to our survey identified the following five factors as having the greatest influence on their performance goal setting process:

For performance measures that can tie directly back to the annual budget, the budget is a very common way to establish “target” performance expectations. This can be effective and appropriate, so long as there is high confidence among the board and management team that the annual budget represents the proper amount of rigor deserving of target incentive payouts. But the budget is not terribly helpful at setting performance expectations appropriate for “threshold” or “stretch/maximum” payouts. This is where observations regarding historical performance, both for your institution and your peers, can be extremely helpful.

Evaluating actual performance against the selected measures over the last several years (preferably five or more) can provide excellent information about the likelihood of achieving specific performance outcomes and can help you to be confident that the appropriate rigor is represented at all payout opportunity levels (i.e., threshold, target and maximum). A rule of thumb for the rigor of performance expectations is as follows:

  • Threshold performance/payout should be achievable about 80 percent of the time
  • Target achievable 50 percent to 60 percent of the time
  • Stretch/Maximum achievable only 10 percent to 20 percent of the time

Observing historical performance is an excellent way to calibrate the performance expectations with the respective payout opportunities and to understand directional trending on specific measures.

Most of the attention and speculation by investor groups surrounds the potential for insufficient rigor in the performance expectations, relative to the payout opportunities. This is a valid concern. It’s also a valid concern when performance expectations are unreasonably high, relative to payout opportunities, because that could discourage employees or potentially encourage them to expose the bank to excessive risks in pursuit of otherwise unattainable levels of performance. A little effort and historical data can go a long way toward addressing both concerns.

Selecting incentive performance measures and establishing the performance expectations are not routine, one-meeting-per-year exercises. If conducted in a thoughtful, intentional manner, your incentive plan design in the first quarter of 2016 can truly support your business strategy and drive behaviors that lead to growth in the value of your company. Make 2016 the year that you challenge—and improve—your incentive goal-setting process.

Incentive Plans: Who Makes the Cut?

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incentive-pay-1-11-16.pngBanks frequently ask the question: Who should be included in their various performance-based incentive plans? Of course the answer to this question isn’t clear cut. This article attempts to put some clarity—and statistics—behind this decision for both cash-based and equity-based incentive plans.

Cash-Based Incentive Plans
The eligibility for performance-based annual cash incentive plans ranges from zero employees to all employees. Yes, some banks still use a completely discretionary cash incentive or bonus program. The discretionary approach is not best practice, but is still prevalent. Today’s employees want to know what they need to do in order to receive a bonus, and companies are better served by giving these employees some clarity.

Budgeting for performance-based cash incentives can be relatively easy. Start by determining how much you are willing to share and what you can afford to share. It is recommended that you establish a minimum profit amount, or income trigger, that must be achieved before any cash incentive is paid. This gives you some cushion and protects your company and shareholders from paying bonuses it can’t afford. Once you have built in the cushion, run some cost estimates based on your eligible employees and their potential incentive awards.

The truly difficult part for performance-based cash incentive plans is the goal setting. Identifying overall company goals should not be complicated (lean on your strategic plan), but the individual and department goals may be challenging. It’s easiest to establish goals and track performance for production-focused positions. However, for operations-focused positions, companies sometimes decide to either base these positions’ annual incentive solely on corporate goals or “throw their hands up” and move to discretionary goals. It’s not easy, but banks should work to establish objective goals. You may not get it perfect the first time, but keep working on it. Goal setting is a process that you get better at over time.

So who should participate? Our Blanchard Consulting Group 2015 Bank Compensation Survey (which included 124 public and private banks and 140 positions) gathered data on bonus payments, incentive award opportunity levels, and the prevalence of performance-based incentive plans. The survey showed that the use of performance-based incentive plans increases with the size of the organization (from 41 percent prevalence in banks below $500 million in assets to 72 percent prevalence in banks above $1 billion in assets). The target award opportunity levels generally ranged from approximately 30 percent of salary for executives down to 2 percent of salary for entry level positions. One interesting finding from the survey was that every position had cash bonus/incentive amounts being paid. This doesn’t mean every bank paid bonuses to everyone, or that they were all based on performance, but it does mean there were at least a number of banks that paid bonuses all the way throughout the organization. Ultimately, the decision is up to each bank, but it is recommended that all full-time positions be eligible to participate in the cash incentive plan.

Equity-Based Incentive Plans
The days of having stock-option plans that include all employees in the bank are long gone. Equity-based plans are far more prevalent in the executive and officer group than other employees. However, some banks are still using equity at lower levels in the organization. The Blanchard Consulting Group 2015 Bank Compensation Survey gathered data on equity plan prevalence, employee eligibility in banks with a plan, and grant prevalence over a multi-year period, from 2012 to 2015.

The findings showed that much like cash incentive plans, the prevalence of equity-based plans increases with the size of the organization: 26 percent of banks below $500 million in assets have equity-based plans and 55 percent of banks above $1 billion in assets have them. The most interesting findings from our equity review surrounded the eligibility data. Not surprisingly, 70 percent of executive level positions had equity plans. These numbers dropped to below 10 percent for some entry level positions, but surprisingly, the mid-level positions showed eligibility in the 20 percent to 40 percent range. The actual grant prevalence data over a multi-year period was generally above 75 percent for executives and stayed above 40 percent for many mid-level positions. This shows that banks with an equity plan are using it well below the executive level.

In summary, it seems clear that banks are leaning towards including more of their employee base in their cash and equity-based incentive plans when they have these programs. This requires extra work in administration and communication, but hopefully is creating an engaged staff that is driving towards the success of the bank in a unified way.

Keeping Your Compensation Committee On Track During the Busy Winter Season

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executive-compensation-11-11-15.pngThe Dodd-Frank Act, regulatory guidelines on compensation risk and shareholder advisory votes on executive compensation have all contributed to an increase in the compensation committee’s responsibilities and time requirements. That pressure is compounded this time of year as committees enter their “busy season.” The fourth quarter is the start of many critical and often scrutinized committee activities: reviewing performance, approving 2015 incentive awards and developing 2016 performance incentive plans.  This article provides a sample full year committee calendar and a checklist of activities and actions compensation committees should be focusing on during Q4 2015 and Q1 2016.

It is best practice for compensation committees to define and schedule their annual activities for the year in advance. A well-defined calendar helps members better plan and prepare for the critical, and often timely, decisions that are required. There are three key cycles to the annual calendar: Assessment, Program Design and Pay Decisions.

Assessment occurs during the more “quiet” months following the prior year’s performance cycle where pay decisions are made, but before the start of the next performance cycle when a new program starts. For companies whose fiscal year follows the calendar year, this typically occurs between June and October (following most public company annual meetings). While there may be less pressure to approve and take action during this time, the analysis conducted during this phase will be critical for decisions made later in the year. Compensation committees should use this time to reflect on the pay program and decisions of the prior year and assess peer, market and regulatory trends that might influence programs in the coming year. This is a perfect time to conduct robust tally sheets, assess the pay and performance of your company relative to peers, conduct peer/competitive benchmarking, and if you are a public company, review say-on-pay results and conduct shareholder outreach. Information reviewed during this phase provides the foundational knowledge needed for the upcoming design and decision cycles.

Program Design typically occurs in the late fall and early winter (e.g. November–January), when compensation committees review the assessment phase results and begin defining total pay opportunities and programs for the upcoming year (i.e. base salary, annual and long-term incentive opportunities and performance goals). Compensation committees should pay careful attention to performance metric selection and goal setting to ensure proper pay-performance alignment. It is also critical to ensure the incentive plans support sound risk management practices. Many banks will complete their annual incentive risk review at this time. This is also an opportune time to consider implementing or revising compensation policies or practices, perhaps in light of shareholder feedback.

Pay Decisions occur in the late winter (e.g. January–April). During this phase, performance evaluations are conducted and decisions are made related to incentive payouts. Pay opportunities for the new year are also set, including annual incentive opportunities and long-term incentive grants. All banks should have conducted their risk assessment review by this time as well. Once Section 956 of the Dodd-Frank Act is finalized, banks will be required to provide documentation of their risk review to regulators. For companies whose fiscal year ends at the end of the year, this will occur during the same timeframe, in the late winter or early spring. This is also a very busy time for public companies that are required to document the prior year’s pay decisions in the proxy in preparation for shareholder review. Many committees spend several meetings discussing these issues.

Periodic activities include, but are not limited to: executive and board succession planning, incentive risk assessment, board and committee evaluations, consultant evaluations, benefit plan review, employment agreement/severance arrangement review and shareholder engagement.

Ongoing updates throughout the year include incentive payout projections and regulatory updates.

Below is an illustration of a typical compensation committee annual cycle with a check list of key activities for Q4 and Q1:

Today’s environment of increased scrutiny on executive compensation and governance requires compensation committees to spend more time fulfilling their responsibilities. Having a well-planned calendar, with a heightened focus on the “off season” assessment activities, can help committees be better prepared for the many critical year-end decisions.

*Section 162(m) of the Internal Revenue Code allows public companies to deduct performance-based compensation above $1 million if it meets specific requirements.

How to Set Performance Metrics that Drive Success

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incentive-pay-10-12-15.pngGenerally bank incentive programs reward team members for the achievement of bank-wide financial results. However, important goals which actually build value, such as customer retention, operational improvements and talent management, are often overlooked. Strategy-based compensation marries a bank’s compensation programs with its business strategy, rewarding team players for performance which results in the achievement of strategic objectives. A helpful tool in designing a program that works is a strategic road map, which clearly identifies activities and players needed to achieve results and create value for your organization.

Creating Your Strategic Road Map
The foundation of strategy-based compensation is an understanding at all levels of the organization as to which activities are required to achieve the stated objectives. A road map to execution will identify the focal points—financial/capital requirements, customer consideration, technology needs and the alignment of talent—as well as the value drivers to push success. Laying out your strategy demonstrates team placement and individual responsibilities within the broad scheme. The illustration below is a hypothetical strategic map for a community bank. Efforts in talent management, operation process, and customer satisfaction ultimately drive the desired financial outcome: growth in income and shareholder value.

Incentive Design Considerations
Among banks, executive incentive plans typically measure bank-wide performance across three buckets:

  • Balance sheet goals (e.g. growth in loans and deposits);
  • Earnings (e.g. return on assets and/or equity); and
  • Portfolio quality (e.g. regulatory ratings, non-performing assets, and/or net charge-offs).

As demonstrated in the strategic map above, these financial metrics are outcome-based and generally reflect the results of efforts. Limiting the overall focus of incentive plans to financial objectives potentially limits the program’s ability to reward and motivate the actions required to realize the success of the business strategy. Forward-looking organizations support differentiating their incentive programs beyond the typical financial focus.

From an executive perspective, incentive plans can incorporate value-driving performance metrics such as:

  • Growth in deposits from new accounts;
  • Expansion of lending activities specifically tied to new markets;
  • Identification of acquisitions;
  • Increases in operating efficiencies, new technology platforms;
  • Demonstration of robust succession planning efforts beyond; and
  • Customer satisfaction and usage.

Below the executive level, team members should be rewarded for areas within the strategic map that they can directly impact. For example, branch managers or operation officers are instrumental in increasing efficiencies and improving customer experiences. However, these individuals have limited line of sight and impact on loan growth or capital requirements. Linkage of incentives to particular elements of the strategy map drives towards the stated strategic outcome.

Goal Setting
Equally as important in the incentive design process is setting performance goals. Designing an incentive plan to drive performance beyond the day-to-day requires setting goals with sufficient stretch to push superior market performance. Testing where your target performance goals sit relative to your bank’s and your peers’ past performance, as well as market expectations, demonstrates the rigor of your goals. For example, from a financial perspective, is the achievement of your loan growth target a walk in the park or a more difficult and dramatic home run?

In addition, setting performance goals requires an understanding of the timelines for execution. The strategic map should illustrate the milestones required to execute your objectives and your short- and long-term incentive programs should align accordingly. For example, entry into a new market may require the identification of a branch to acquire or new construction, as well as staffing. The time frame required to complete these activities and their successful deployment is likely to vary and may not be easily compartmentalized in a typical incentive plan performance period of one or three years. The most successful incentive program designs will demonstrate a level of flexibility.

Driving Performance Beyond the Day-to-Day
Incentive programs are powerful tools when designed properly. The program’s design should dovetail with your business objectives, timeframes, and lines of sight among participants. Further, these programs should be frequently monitored, reviewed, and revised as appropriate to ensure they support your bank’s evolving strategic objectives, thereby driving performance beyond the day-to-day.

It’s a New Day in Executive Pay

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12-3-14-Naomi.jpgEver since the financial crisis, bank boards have been operating under a tremendous amount of scrutiny, and that is leading to substantial changes in pay packages. Changes that at first only impacted the largest, global banks are cascading down to smaller community and regional banks.

People such as John Corbett, the CEO of the $3.9-billion CenterState Bank of Florida, headquartered in Davenport, Florida, say their banks are paying executives more of their total compensation in long-term equity. If the bank’s shareholders do well, so do the executives, so the thinking goes. Half of the stock is time vested, meaning it takes a few years before executives have access to it. The other half is tied to performance goals. Also, the bank’s annual bonus plan for top executives is a mix of cash and stock, and the bonuses are deferred for three years in case the credit quality of the bank’s loan portfolio deteriorates.

Corbett spoke at Bank Director’s Bank Executive and Board Compensation Conference last month in Chicago.

Kevin O’Connor, president and CEO of Bridge Bancorp, Inc. in Bridgehampton, New York, also spoke at the conference and said his more than $2-billion asset banking company has made substantial changes, adding long-term incentives in the form of equity, tying those to individual and corporate performance, and requiring vesting periods for the stock.

O’Connor said not all banks provide employees with as much transparency into exactly how the bonus plan works as Bridge Bancorp does now. But his bank’s plan has generated more discussion about how to reach corporate and individual goals, and he feels good about that result.

“[Employees] want to know what the corporate goals are,’’ O’Connor said. “They want to know how they can affect it. What I like is there is actually a dialogue now with the manager as to what they should be focused on.”

Other changes that are happening in bank pay plans include:

  • More publicly traded banks are using restricted stock. The stock typically vests over a three-to-five year period, to provide a retention tool, or vests based on achievement of specific performance measures. Common performance measures include the company’s shareholder return relative to a peer group, return on assets, or earnings per share. Goals for the highest executives tend to be focused on corporate performance, while lower level employees have more weight given to individual and department goals. Private companies can offer incentives in the form of “synthetic stock” or “phantom stock” that increases in value with the company’s value, and is ultimately paid in cash.
  • Long-term incentives are an increasingly important part of the average executive’s pay, but the percentage varies greatly by size of bank. For example, CEOs at banks above $1 billion in assets on average receive 26 percent of compensation in long-term incentives, typically stock, according to a review of about 150 publicly traded companies by Blanchard Consulting Group. For banks between $500 million and $1 billion in assets, the percentage of total compensation that is long-term is 12 percent.
  • Stock options are going away. Regulators have a “stated disdain” for stock options, according to compensation consultant Todd Leone of McLagan. “They have been slowly dying on the vine,’’ he said. Powerful shareholder advisory groups, such as Institutional Shareholder Services and Glass Lewis & Co., don’t consider stock options tied to performance.
  • Gone are the days of executives getting change-in-control payouts when a sale occurred even when they didn’t lose their jobs. The payouts also are smaller, in the range of two to three times base pay, rather than four or five times base pay as was common five or six years ago, said Barack Ferrazzano attorney Andy Strimaitis.

Figuring out how to pay top executives has always been a huge challenge for the board. You don’t want to lose top talent to competitors, but you also don’t want to give overly lavish pay packages, either. There is no one way to do this. There are plenty of ways to get your bank in trouble with regulators or ensure a negative say-on-pay vote at the annual shareholders’ meeting, but each board has to come to its own decision about what makes an optimal pay package.

How Regulators are Changing Bank Incentive Pay

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6-9-14-meridian.pngThe Federal Reserve’s influence on incentive practices at the largest banks is cascading to regional banks. Although the final Dodd-Frank Act regulations have not been released, many banks are adjusting their incentive programs to respond to regulatory pressure. A Meridian Compensation Partners review of proxies of U.S. banks with $10 billion to $400 billion in assets confirmed that changes continue to emerge in the following areas:

Decreased stock option use.
While slightly more than half (53 percent) of banks continue to include stock options in their portfolio of long-term incentives, the value of such awards declined 30 percent from 2012. Regulators deem stock options as a more risky form of compensation. Most banks granted two to three forms of equity as part of their long-term incentive program in 2013, with stock options representing the smallest portion.

Increased use of performance-based equity.
In place of stock options, performance-based shares have become the most prevalent stock instrument, used by 74 percent of the banks. Performance shares reward future performance, typically over three years, against measures such as total shareholder return (42 percent of those surveyed used TSR), return on equity (38 percent used), earnings per share and return on average assets (both used by 27 percent). Some banks used multiple measures to determine performance share awards.

Reduced use of relative metrics.
For performance-based equity plans, relative performance metrics continue to be prevalent, particularly due to the challenge of setting long-term goals in today’s business environment. Yet, regulators fear overuse of relative metrics leads to risk taking and “chasing” of performance peers. As a result, we are seeing an increase in the use of absolute measures in long-term plans: 17 percent use absolute measures and 46 percent use a combination, while 37 percent continue to use only relative.

Reduced leverage.
Over the last few years, regulators have been pressuring the largest banks to reduce the maximum upside opportunity in incentive awards, particularly within long-term plans. While maximum opportunities of 200 percent of target remain standard in general industry, 125 percent to 150 percent caps are now standard at large banks.

Increased prevalence of forfeiture provisions.
While clawbacks have emerged as common practice despite the lack of final Dodd Frank rules regarding clawbacks, these policies will be challenging to enforce. It is easier to adjust pay before the award or vesting, rather than after pay has been doled out. About 30 percent of banks have forfeiture provisions on incentives prior to award or vest. Such provisions allow for potential reduction of outstanding cash and equity grants in instances of negative earnings, returns, and/or “bad risk behavior.” Many banks provide for the adjustment or forfeiture of equity vesting based on an assessment of individual actions (e.g. violation of risk policies).

While some of these emerging trends conflict with the desires of shareholders and other constituencies to reward high performance, they nevertheless represent reality for today’s banks. As organizations consider these practices, it is critical to take a holistic view of the bank’s compensation philosophy and programs to ensure they are balanced, support the business strategy, align pay and performance and appropriately mitigate risk. Incentive plans should:

  1. Be grounded in bank strategy. Performance measures should clarify and communicate what’s important to focus on (short and long-term) as well as the level of performance expected.
  2. Incorporate a balanced portfolio of performance perspectives. No one measure effectively reflects performance. Annual incentive measures should align with your bank’s annual business plan while long-term incentive measures should reflect sustained value creation and shareholder value. Banks should understand the total incentive opportunity (short and long-term) that is allocated to different performance perspectives (e.g. profitability, growth, shareholder return, individual performance) to ensure it reflects the desired mix and focus.
  3. Balance discretion and formula. While the Securities and Exchange Commission and shareholders like to understand the performance goals and resulting performance to assess pay-performance alignment, regulators prefer discretion, particularly with respect to risk considerations. More banks are using a combination of financial measures and discretion to provide a more holistic review of performance.
  4. Incorporate risk adjustments. Consider forfeiture provisions that provide for reduced payouts or clawbacks.

Expect CEO Pay to Rise in 2013

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6-21-13_Moss_Adams.pngWestern bank CEOs and their direct-report executives should expect average salary increases in the 3 to 5 percent range during 2013, according to a survey by assurance, consulting and tax firm Moss Adams LLP. Also, the industry should expect a nearly 50 percent reduction compared to 2012 in the number of institutions that continue to subject their executive officers to a salary freeze.

According to the 2012 Community Bank Compensation Survey conducted with Western Independent Bankers, the executive compensation banks are providing continues to show a strong correlation with the institution’s operating performance. The survey found compensation strategies continue to favor incentive-based compensation over salaries in order to place a greater emphasis on variable costs for the retention of key executive officers. However, as the economic recession gives way to recovery and many more banks return to profitability, we’re beginning to see more focus and attention given to executive compensation programs, particularly with respect to incentive pay components.

We also found that operating performance objectives, return measures and top-line growth continue to be primary considerations in establishing annual incentive compensation levels, while executive retention strategies are becoming more of a factor. While these compensation-related measures remain consistent from previous years and from bank to bank, nearly 50 percent expect to raise performance hurdles for measuring overall incentive compensation available in 2013. Long-term incentive award levels are also trending up modestly in 2013, with the award packages still relying heavily on time-vested restricted stock but increasingly including performance-vested stock awards.

In addition to these salary and incentive-based compensation expectations, the survey identified a number of emerging trends.

Increased Incentive Pay
Executive compensation is increasingly being delivered through incentive pay. It’s evident that there is a greater alignment of pay and performance, and incentive pay programs have a greater focus on long-term performance and risk outcomes. Equity-based incentives that defer compensation through multiyear vesting and mitigate compensation risk appear to be gaining favor.

More Performance Factors
Boards of directors and their compensation committees are taking a broader view of relevant performance factors in setting incentive-based compensation. An entirely discretionary approach to incentive compensation payouts is giving way to a formulaic approach dependent, in many cases, on multiple measures. Earnings measures remain the prominent factor, although returns on equity, capital levels, credit quality, and asset growth represent alternative metrics that are also considered.

Increased Documentation
When discretionary measures are used as the primary determinant for executive incentive compensation payouts, increased rigor and documentation is expected. We expect regulators to be more probing about the structure surrounding discretionary payouts to ensure decisions are justified and consistent. We expect compensation committees to refine their approach to discretionary payouts through the use of scorecards that will reflect absolute goals moderated by some subjective judgment tied indirectly to specific metrics or goals. Clawback provisions for incentive-compensation payments continue to be limited in application and complicated to enforce.

More Long-Term Incentive Strategies
Multiple long-term incentive strategies are expected to emerge with an increased use of performance-based vesting and increased responsiveness to shareholder interests and market trends. While performance-based incentive programs increase in application, time-based awards are expected to remain, balancing the mix if poor risk outcomes materialize prior to vesting.

More Transparency
More transparency in compensation reporting will become the norm, as say-on-pay provisions and public company advisory votes on executive compensation have raised reporting expectations. Proxy disclosures related to how compensation decisions are made, how performance criteria were established and how performance results led to incentive payments are expected to improve reporting clarity.

As boards of directors and their compensation committees continue to explore business planning strategies, risk tolerance measures, executive goal setting and the use of defined metrics in performance measurement, they will be better equipped to make even more meaningful connections between expected business performance and executive compensation in the future.

ABOUT THE SURVEY
The Moss Adams annual survey was conducted in 2012 with Western Independent Bankers. The compensation report includes responses from 123 institutions that range in size from less than $50 million in total assets to over $2 billion across the western United States.

The Future of Executive Compensation

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fortune-cookie.jpgEveryone from shareholders to regulators wants a “say on pay” these days, but compensation committees must continue to ensure their programs attract, retain and motivate executive talent in a way that is aligned with the bank’s strategy and culture.

Meridian recently completed a study of CEO compensation practices at 58 publicly-traded banks with assets between $1 and $5 billion. Based on our work with clients and the results of our research, we anticipate the following will be some of the key trends in executive pay as compensation committees work to balance competing expectations.

Increase in percentage of pay delivered through incentives.  In our study, on average, base salary comprised half of CEO total direct compensation (base salary, annual incentive and long-term incentives). Incentives have become a larger component of total pay over the past few years, and we anticipate that trend will continue as shareholders expect a more direct alignment of pay and performance. The majority of this increase will likely come through equity-based long-term incentives, which defer compensation through multi-year vesting and payment schedules and help mitigate the overall compensation risk.

Broader view of performance. With the rising regulatory focus on the perceived risk of compensation programs, committees are using a variety of performance factors to determine incentive payouts. Some committees use a fully discretionary approach to determining incentive payouts, which typically involves a holistic review of performance. Banks with formulaic approaches to annual incentives are increasingly using multiple measures, and we expect the trend to continue. Almost half of the banks in our study included four or five measures in their formula, while only 20 percent rely on just a single measure. While earnings measures (e.g. earnings per share) remain prominent, banks are also including measures focused on returns, capital levels, credit quality, and growth.

Increased rigor around discretion.  Regulators have recognized that discretion can play an important role in ensuring that payouts appropriately reflect risks taken during the performance period, as well as make it less likely that executives will manipulate performance results to increase payouts.  However, they expect sufficient structure around discretion so that decisions can be justified and made consistently. Shareholders and their advisors generally prefer formulaic plans, but will accept the use of discretion if it is reasonable and well explained. More than 80 percent of the banks in our study indicated that their committees use discretion in determining incentive payouts. We anticipate committees will refine their use of discretion to include the development of scorecards that reflect a variety of measures from both an absolute and relative perspective, as well as principled guidelines that specify the types of circumstances that will trigger discretionary adjustments.

Use of multiple long term incentives, with increasing use of performance-based vesting.  Among banks in our study, the prevalence of performance-based vesting on long-term incentives doubled from 17 percent to 34 percent between 2009 and 2011. We expect this trend to continue in response to shareholder expectations and broader industry trends. While we expect the use of performance-based long-term incentives to increase, we do not anticipate the elimination of time-based awards. We expect most banks will choose to grant a combination of awards—both performance-based and time-based. Many shareholders and their advisors expect a minimum of 50 percent of long-term awards to be performance-based, but the inclusion of time-based awards can help provide balance. Additionally, many time-based awards will likely begin to include provisions that provide for reductions if poor risk outcomes occur during the vesting period. 

More transparency.  Say-on-pay has given public company shareholders an advisory vote on executive compensation, and their expectations for insight into the committee’s decision making have increased. Likewise, the Securities and Exchange Commission is expecting clear disclosure of performance targets in most circumstances. We expect proxy disclosures to increase their clarity as to how compensation decisions are made, particularly how performance criteria were established and how those performance results led to incentive payouts.   

The banking industry continues to be on the forefront of change in executive compensation due to scrutiny from both regulators and shareholders. Compensation committees must remain vigilant to ensure their executive pay programs balance the increasing expectations of regulators and shareholders while continuing to support bank objectives.

What to Do When Caught Between Investors and Regulators

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hands-tied.jpgIt’s tough to please both regulators and shareholders these days, especially when they want contradictory things. Take the case of executive compensation.

Shareholder groups have been pushing for a greater tie between performance and executive pay. One of the most powerful of these, Institutional Shareholder Services, screens executive pay packages to see how they stack up against peers relative to performance and how the change in CEO pay mirrors change in total shareholder value over five years. ISS recommendations to shareholders on such matters can strongly influence a company’s say-on-pay shareholder advisory vote. Umpqua Holdings Corp. and other banks found this out, as described in a recent story in Bank Director magazine.

But looking at the stock price and shareholder value is exactly what regulators don’t like.

Jim Nelson, a senior vice president of supervision and regulator for the Federal Reserve Bank of Chicago overseeing large banks and savings institutions, is concerned with the use of stock price or return on equity as a measure of performance in making pay determinations. Return on equity doesn’t factor in the risk that executives might be taking to achieve such returns, he said at Bank Director’s Bank Executive & Board Compensation conference recently in Chicago.  There are many factors that can influence the stock price which are outside the realm of management’s control, he said.

“We think most of the people in the firm don’t have a direct impact on the value of the stock price,’’ he said. “We’re looking for a measurement tied to something that that person does control.”

Regulators also explained how they feel about shareholders in their 2010 Guidance on Sound Incentive Compensation Policies, which applies to all banks and thrifts.

The joint regulatory guidance says “shareholders of a banking organization in some cases may be willing to tolerate a degree of risk that is inconsistent with the organization’s safety and soundness.”

So there’s the rub. Do you please shareholders or do you please regulators? But there are ways to combine the concerns of both.

“It’s not the amount [of bonus or incentive pay],’’ Nelson said. “What we’re looking at is the arrangements. You should reward individuals who are producing an attractive risk-adjusted return for you. If they are making more money with low risk, they should be paid more than someone who is making money with high risk. I think that is aligned with what shareholders want and the board wants. There is a lot more free enterprise in this approach than people think.”

He said some big banks are adjusting their profits based on risk metrics before handing out bonuses.

Meanwhile, big banks also are taking into account the needs of shareholders and the recommendations of shareholder advisory groups. Tying short and long-term bonuses, at least in part, to shareholder return is one way to do that.

For example, Buffalo, New York-based First Niagara Financial Corp., one of the nation’s 25 largest bank holding companies with $35 billion in assets, paid out long term incentives to top executives in three ways: stock options, time-vested restricted stock and performance-based restricted stock that vests in three years based on total shareholder return relative to the SNL Mid-Cap Bank Index.

Barbara Jeremiah, a First Niagara director who chairs it compensation committee, said when the bank ran into troubles trying to raise capital for its acquisition last May of HSBC branches in New York and had to cut its dividend in half, the board recognized the hit shareholders took and wasn’t locked into paying short-term bonuses based on earnings per share. The board had made sure it had some level of discretion in determining the bonus, she said.

The board adjusted incentive compensation for CEO John Koelmel to reflect the decline in stock price and reduction of the dividend. Jeremiah encouraged compensation committee members and human resources directors at the Bank Director conference to read and stay abreast of how others viewed executive pay, making note of an article by Gretchen Morgenson of The New York Times entitled  “C.E.O.’s and the Pay-‘Em-or-Lose-‘Em Myth.”

 “We need to keep that outside view,’’ Jeremiah said. “How do our customers and others view us?”