Banks Make Changes Following Wells Fargo Crisis

incentive-12-16-16.pngIt seems almost everyone with a bank account knows the story: a relatively small group of people within a large organization committed fraud by opening unapproved customer accounts in order to earn performance bonuses under a production-based incentive plan. The scandal badly bruised the bank’s stellar reputation, forced the CEO to step down, and resulted in a significant loss of shareholder value, before the election turned the tide for many bank stocks.

It has also prompted a widespread industry examination of retail incentive practices. Whether it is through the OCC’s horizontal review of sales and marketing practices or board requests at smaller community banks, the industry is taking a look at both the cultural aspects of sales expectations and the design and controls of the programs themselves.

In November 2016, Pearl Meyer conducted a survey of actions banks are taking to address the potential issues uncovered by the scandal. This study included 57 respondents representing both small and large institutions across the country. The key outcomes indicate that four out of five banks have had an internal or external inquiry regarding their retail incentive plan practices. Most banks are unlikely to make significant changes to their retail incentive plan design and instead are focusing on communication and training as well as enhanced documentation, controls and monitoring.

The aftermath of the Wells Fargo scandal will be that banks are expected to examine their retail incentive programs and the controls supporting them. To that end, we believe there are five questions that banks should ask and answer with respect to their retail incentive programs.

What does our plan reward? About half of respondents to our bank survey indicated using volume metrics and cross-selling metrics (55 percent and 47 percent respectively), which have been criticized as a part of the scandal. However, few are planning to discontinue these metrics (6 percent to discontinue volume and 4 percent to discontinue cross-selling). Use of either metric may put additional pressure on banks to demonstrate how their controls and administrative procedures curtail fraud or misconduct.

Approximately 70 percent of respondents use growth metrics and 34 percent use profitability or revenue, which are much more difficult to manipulate. Nearly one-third have a discretionary component for branch or individual performance that can help reinforce positive behaviors and “right size” awards.

How is our plan monitored? Participants received inquiries from executive management (72 percent) and their boards (51 percent) who may be unfamiliar with the specific details of the retail incentive programs. Banks are addressing the additional oversight through increased monitoring and controls (46 percent) and greater reporting to senior management or the board (42 percent). Reporting elements need to remedy the fact that boards have a responsibility to ensure the bank’s incentive compensation arrangements do not encourage inappropriate risk. Directors often have no visibility into retail incentive plans, have no easy way to quickly understand the impact, do not know what their rights or authority are in understanding, determining, and remedying the risk, and have no plan for how to react. These issues need to be addressed to appropriately monitor the risk.

Are our expectations reasonable? The last element of reporting—how many employees are meeting performance goals—can identify unreasonable expectations or flag the need for better training or management. Collecting performance data over time to see trends in performance, expectations and payouts may also prove useful.

What are our customers experiencing? More than a quarter of respondents indicated that they will develop or enhance their customer complaint process. The process should not only handle specific complaints but also aggregate the complaint types to identify systematic breakdowns in the customer experience.

Are we staying true to our values? Critics have indicated that perhaps the largest failing at Wells Fargo was an environment where branch staff feared that nonperformance would result in job loss. Monitoring of employee satisfaction by business line and mechanisms to provide feedback without repercussions can help identify problems before they escalate.

Given the large-scale publicity of the Wells Fargo scandal, someone—customers, employees, regulators, or shareholders—will likely ask how your retail incentive program is different and what you have done to protect against fraud or misconduct. Accordingly, banks should conduct an assessment of retail incentive plan designs, risks and controls, as well as gain a better understanding of the branch sales culture and leadership.

Bank Compensation: How Banks are Changing Bonus Plans

compensation-10-26-16.pngThe problem with creating an incentive plan is that your employees just might do whatever you incentivize them to do. If you pay bonuses based solely on earnings growth, then you might not only get growth in earnings but also really bad loans that eventually sink the bank. If you don’t include the quality of the bank’s ratings with regulators in the performance metric for your CEO, then you might end up with a bad regulatory rating.

During Bank Director’s Bank Executive and Board Compensation Conference on Amelia Island, Florida, yesterday, it became clear that many banks in the wake of the financial crisis are beginning to incorporate a variety of mechanisms to incentivize the behavior they want from their employees and management.

  • Fifty-nine (59) percent of banks in a Blanchard Consulting Group 2016 survey of more than 200 public and private banks have some kind of formal performance-based incentive plan for management. Only 22 percent have a bonus plan that is solely discretionary, according to the survey. This is of increasing importance for publicly traded banks as well. The shareholder advisory group Institutional Shareholder Services recommends that at least 50 percent of a CEO’s shares be tied to performance, said Gayle Appelbaum and Todd Leone of consulting firm McLagan.
  • Sixty-eight (68) percent use net income as one of the metrics in their performance-based incentive plan for the CEO. Seventy percent use it as a metric when evaluating the senior management team. It is more difficult for management to manipulate net income in their favor compared to return on assets or return on equity, said Mike Blanchard, CEO of Blanchard Consulting Group.
  • In a survey of the audience at the conference, which consisted of roughly 225 attendees, 35 percent used asset quality as the primary non-profitability metric in their incentive compensation plan. Regulators want to see other metrics besides profitability in bank incentive compensation schemes. “Be careful if you have profits only,” Blanchard said. Building in a little bit of discretion for the board in setting senior management pay is a wise idea, rather than basing incentives solely on metrics, Blanchard said. That could give the board more flexibility when something has gone wrong.

Banks are increasingly using clawback measures or deferral of pay to reduce the risk of their compensation plans. A clawback measure could be similar to one used by Wells Fargo & Co.’s board recently when departing CEO John Stumpf forfeited $41 million in unvested stock and Carrie Tolstedt, the former head of consumer banking, forfeited $19 million, following a fraudulent account opening scandal. Clawing back unvested stock is helpful because it’s difficult to clawback pay when the executive has already received it, and presumably, spent it. Some banks are adding clawback provisions to their incentive compensation plans that allow the board to clawback for unethical behavior or reputational damage to the firm.

With Wells Fargo in the headlines, questions about incentive pay and motivating the right behavior were a big focus of the conference, although not the only one. Most speakers thought Wells Fargo’s crisis was more related to its culture and how management responded to problems, rather than its incentive plan.

Chris Murphy, the chairman and CEO of 1st Source Bank in South Bend, Indiana, a $5.4 billon asset institution, talked during a panel discussion at the conference about building integrity and character among staff. If someone violates the basic values of the company, he wants other employees to know why that person was let go. A reputational crisis could hurt the bank financially but it’s an even bigger deal than that. “We now understand a little better the impact of little things building up over time,’’ he says. Lying is a nonstarter. “You can’t have anyone lying in any way, shape or form in your organization.”

Mega-Acquirers: Compensation Practices That Make a Difference

As football coach Lou Holtz famously stated, “In this world you’re either growing or you’re dying, so get in motion…” In the past two years, 545 banks have been acquired—the highest level of activity since 2006 to 2007. During this busy cycle, the regional public banks between $5 billion and $50 billion have enjoyed greater profitability than either their smaller or larger counterparts.

With improving financial markets, increasing regulatory requirements, and decreasing margins, some of these regional banks have been executing an acquisition growth strategy for several years. Pearl Meyer identified 22 “mega-acquirers,” banks in the top quartile of regional banks ranked by three-year asset growth. These mega-acquirers have averaged a three-year asset growth rate of over 30 percent, compared to just over 7 percent for other regionals. Not only do they outperform in asset growth, but also on a number of other key financial metrics.

Median Financial Performance of Mega-Acquirers Versus Other Regionals (as of 12/31/2015)

  3-yr Asset CAGR (%) Price/Tangible Book (%) TSR CAGR (%) Diluted EPS after Extraordinary Items CAGR (%)
1-Yr 3-Yr 5-Yr 1-Yr 3-Yr 5-Yr
Mega Acquirers (n=22) 31.58 171.48 21.63 21.56 16.55 25.56 20.12 9.82
Other Regionals (n=89) 7.30 158.87 7.62 15.19 9.97 3.39 6.85 5.29

CAGR: Compound Annual Growth Rate
TSR: Total shareholder return defined as stock price appreciation plus dividends Source: S&P Global Market Intelligence

Pay Differences
While there are many factors that can influence financial success, we looked specifically at whether or not mega-acquirers structure executive compensation differently. The answer is yes and no. The median pay of CEOs for the mega-acquirers and other regionals aren’t markedly different. The mix between base salary, annual incentives, and long-term incentives for CEOs also were generally consistent for all regionals. There were, however, three key differences.

  • Mega-acquirers manage to results. Fewer mega-acquirers have an annual incentive plan with a discretionary component (33 percent versus 46 percent for other regionals), potentially inferring that mega-acquirer executives are accountable for achieving financial goals regardless of the external environment.
  • Mega-acquirers focus on both revenues and cost. While all regionals use net income as a metric equally, mega-acquirers are more likely to include an efficiency ratio in their annual plans (27 percent versus 17 percent for other regionals).
  • Mega-acquirers tend to use more time-vested restricted stock and fewer performance shares. Curiously, mega-acquirers are getting good financial results without the use of performance-based equity. Eighty-two percent (82 percent) of mega-acquirers provide time-based equity awards to their CEOs versus 73 percent for other regionals. Prevalence of performance-based shares is 36 percent for mega-acquirers versus 51 percent for other regionals.

While we can only speculate why there is a greater preference for restricted stock rather than performance shares, there are a couple possibilities. First, performance shares often vest based on achieving operational metrics. The argument may be that future operational performance is a function of what is acquired and this can be hard to pin down even if it is measured on a relative basis. Second, while median stock ownership for mega-acquirer CEOs is similar to other regionals, it is more than twice that of regional CEOs at the 75th percentile. There may be a strong desire by some of the mega-acquirers to ensure that the CEO has meaningful share ownership and is willing to achieve this through time-based vesting. In our experience, actual share ownership is what drives behavioral shifts and creates shareholder alignment.

These pay differences are subtle. However, when you combine strategy, financial results, and pay practices together, the implications provide for compelling discussion in the boardroom.

Has the use of discretion in incentive plans gone too far? Discretionary components are inappropriately used if they are a way of explaining away poor performance on the defined metrics. Discretion is best used when it is a qualitative assessment of non-financial results or where it is difficult to determine financial outcomes due to acquisition or other factors. Establishing what will be evaluated qualitatively at the beginning of the year, rather than at year-end also fosters discipline in using appropriate discretion.

If there aren’t meaningful differences in CEO compensation values, are you getting what you are paying for? Holding CEOs and their executive teams accountable for strategy deployment and financial results is a primary board responsibility. Open and honest feedback coupled with active oversight can ensure the bank is getting value from its compensation dollars.

Are you evaluating the CEO on the right things? Simply focusing the CEO’s evaluation on whether the bank made its numbers that year is insufficient. A more holistic view of the role using seven characteristics should be considered:

  1. Strategy and Vision
  2. Leadership
  3. Innovation/Technology
  4. Operating Metrics
  5. Risk Management
  6. People Management
  7. External Relationships

Compared to both smaller and larger banking organizations, regional banks have enjoyed relatively strong performance despite a challenging operating environment—and mega-acquirer performance has been even stronger. Has executive pay design played a role in the success of mega-acquirers? The differences in design are small, but potentially impactful—a tighter link to performance, a stronger focus on operational effectiveness, and for some, a higher level of long-term equity ownership.

Incentive Plans: Who Makes the Cut?

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.

Compensation for Privately Owned Banks: What to Know

incentive-plan-11-9-15.pngPrivately held banks, including Subchapter S banks as well as mutuals, are no different than publicly traded banks in their efforts to provide meaningful compensation plans for their key officers. Privately held banks must compete with public banks when attracting and retaining key officers and producers.

Publicly held banks typically offer restricted stock or incentive stock options to key employees. This is much more difficult for privately held banks due to a lack of available shares or illiquidity of the stock. Therefore, privately owned banks competing for talent often require more creativity.

While some privately held banks offer stock options, restricted stock or restricted stock units (RSUs), these types of plans are uncommon. Rather, privately held banks that want to provide rights of ownership to executives often use synthetic equity such as Phantom Stock Plans (PSPs) and Stock Appreciation Rights (SAR) plans. While these plans have an earnings impact to the bank, they do not have a per-share dilution as no actual shares are issued.

Competition for top talent is strong. Assuming the bank offers a competitive salary and an annual incentive plan, the challenge is the ability to offer a long-term incentive/retirement plan. The following types of plans are often used to attract and retain key executives and include:

  • Supplemental executive retirement plans (SERP) can be designed to address an executive’s shortfall that would result if the executive only had social security and the bank’s qualified plan to provide retirement income. Generally, under the terms of a SERP, an institution will promise to pay a future retirement benefit to an executive separate from any company-sponsored qualified retirement plan. The benefit is typically expressed as a fixed annual dollar amount or as a percentage of final compensation.
  • Deferred compensation plans (DCP) allow the bank to make contributions to the executive’s account using a fixed dollar amount, fixed percentage of the executive’s compensation, or a variable amount using a performance-based methodology. The DCP can also allow the executive to defer his or her current compensation.
  • Split dollar plans allow the bank and the insured executive to share the benefits of a specific BOLI (Bank-Owned Life Insurance) policy or policies upon the death of the insured. The agreement may state that the benefit terminates at separation from service or it may allow the executive to retain the life insurance benefit after retirement if certain vesting requirements are met.
  • Survivor-income plans/death benefit-only plans specify that the bank will pay a benefit to the executive’s survivors (beneficiaries) upon his or her death. The benefit may be paid in a lump sum or in annual payments over a specified time period. Typically, the bank will purchase BOLI to provide death proceeds to the bank as a hedge against the obligation the bank has to the beneficiaries. The benefits are paid directly from the general assets of the bank.

Picking the right plan design is only part of the process. Striking the proper balance between making the plan attractive to executives but not excessively expensive to the company are also significant factors when designing the benefit plan. Nonqualified plans can be customized to each executive, avoiding a cookie cutter approach by allowing flexibility in the amount of the benefit, vesting schedule, non-compete provisions, timing of payments and duration of payments. For example, assume you provide a substantial retirement benefit to a 40-year-old executive, but provide no vesting until age 65. The executive will likely not see it as a valuable benefit since most 40-year-olds think they will retire long before age 65. Likewise, if the executive is fully vested at age 55, the executive may not be motivated to stay past that age.

The plan must also provide a fair benefit upon death, disability and change in control. The payment terms can be customized to fit the needs of the executive while remaining in compliance with IRC Section 409A of the tax code. A properly designed nonqualified plan can enhance the bank’s bottom line by attracting and retaining top talent, but doing so in a way that is cost-efficient to the bank.

With over 30 years of history, BOLI has proven to be an effective tool to help offset and recover benefit expenses. While many public banks purchase BOLI to recover the cost of general benefit liabilities only, many privately held banks purchase BOLI for the same reason, but also include recovering the cost of nonqualified plans. BOLI is a tax-advantaged asset whereby every $1 of premium equates to $1 of cash surrender value (CSV) on the bank’s balance sheet. The CSV is expected to grow every month and earnings are booked as non-interest income on a tax preferred basis. From a cash flow perspective, BOLI is a long-term accrual asset that will return cash flow to the bank upon the death of the respective insured(s). BOLI is an investment asset that currently generates a return in the range of 2.50 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 4.03 percent to 5.65 percent (assuming a 38 percent tax bracket).

Privately held banks must compete with all types of organizations for talent. Their future is dependent on their level of success in attracting and retaining key executives. The use of nonqualified plans, when properly chosen and correctly designed, can make a major impact on enhancing long-term shareholder value.

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

What Behavior Does Your Incentive Plan Reward?

Nearly all banks, regardless of size, view growth as a key driver of success. What differentiates Bank A from Bank B are the unique strategies they have formulated to achieve that growth. However, when it comes to compensation, regardless of business strategy, there’s often just a single question asked: “How do my peers pay?”

While it is important to understand market norms regarding pay levels and practices, this information is most impactful when followed by additional questions including “What implications do those practices have for us?” and “How can we use compensation in a way that draws the right talent and ensures success?”

Assessing whether or not an executive compensation program is working requires going beyond market data and compliance to determine the program’s degree of alignment with the bank’s business and talent strategies. The following steps can help compensation committees think through this alignment with their program design.

Step 1: Define Path to Success
The ultimate goal of all banks is to create value for stakeholders over the long term. But in the interim, “success” can be defined as the effective execution of the bank’s chosen strategy. For example, an acquisition strategy often seeks to create higher returns and shareholder value through market share and economies of scale. Examples of strategies include:

Strategy Measure of Success
 Acquisition  Higher returns through market share and economies of scale
 Exit/Liquidity (e.g., Sale, IPO)  Maximize growth through capital infusion
 Organic Growth  Stable and growing returns
 Niche  Profitability through higher margin business

Step 2: Consider Compensation Implications
Compensation committees should consider whether the compensation structure is helping execute the strategy and deliver results. Let’s stay with the example of an acquiring bank. When an acquisition is made, there can be significant noise in the financial statements along with one-time merger costs. If the annual incentive program is formulaic and heavily based on income-related metrics, it could very well discourage management from seeking acquisitions. Further, the plan may not be designed to reward key elements that can determine whether or not the benefits of the strategy are realized. For example, in the near term, it may be entirely appropriate to reward executives for bringing quality deals to the board for consideration. Later, executives should be rewarded for ensuring merger integration is timely and efficient.

The following outlines common compensation design challenges and considerations:

Strategy Challenges Considerations
Acquisition Financial results during the acquisition stage are highly variable Does the annual plan include qualitative measurement to account for variability?

Are there adjustments or exclusions for incentive calculations?

Is there greater weight on equity compensation to reward long-term results?

Exit/Liquidity (e.g., Sale, IPO) Short-term profitability and results related to franchise value are important Does the annual plan focus on profitability and results related to franchise value (e.g., deposit and loan growth)?

Is there greater weight on equity compensation to align interests?

Are implications of the change-in-control agreement terms clear?

Organic Growth Results are driven through increases in market share and cost reduction Is the annual plan focused on profitability and moderate growth in key areas?

Is wealth accumulation through equity, retirement benefits or both?

Niche Achieving profitability through higher margin business Is the annual plan appropriately customized for business lines?

Is differentiation in compensation required to hire and retain specialized talent?

Step 3: Tailor the Program
Using our acquisition strategy example, a compensation program might be redesigned so equity encompasses a larger portion of incentive pay, taking pressure off immediate financial results and incenting deals that are accretive over time.  The annual incentives could play a lesser role and continue to use profitability of the legacy lines of business, but would be complemented with measures that focus on deal flow and integration.

Step 4: Revisit and Refine
Compensation committees should test the outcomes of the compensation program annually and refine as necessary:

  • Did the program attract talent and retain our best people?
  • Were pay and performance aligned?
  • Did our results move us toward our strategic goal? If not, did the compensation program play an unintended role in not achieving objectives?
  • Have milestones and objectives changed in a way that the program should be refined?

Moving beyond market practices to align compensation programs to a specific strategy can provide a competitive advantage when it comes to attracting and retaining your best people and driving business results.  Being mindful of the alignment of strategy and the compensation programs that support those efforts ensures that the bank has the best probability for success.

Six Steps for Creating the Ultimate 2016 Producer Incentive Plan

compensation-plan-06-23-15.pngThere will always be strong demand for high performing producers. Incentive plans, when designed correctly, can help attract, motivate and reward the employees who are key to driving the bank’s success.

It may seem straightforward, but if this were an easy and predictable process, banks would spend much less time and energy reviewing and modifying their plans each year. In reality, it’s not easy, but it is critical to create an incentive program that aligns with current business priorities while also considering the factors that motivate your top sales staff.

Keep this list handy because while summer is just beginning, the fact is, it won’t be long before it’s time to recalibrate your plans for 2016.

  1. Know Where You’re Going.  Establishing guiding principles for the incentive plan is often an underappreciated step, but it aligns design decisions with the important operating goals of the bank. Be clear about exactly what you are trying to accomplish. Enhance revenue growth? Sell to new customers or deepen current relationships, or both? Perhaps you simply want to push your best performers to operate at an even higher level than in the past, or for strategic business reasons, you want this same group to shift focus toward a new market. Revisiting these principles will help establish and reinforce the underlying basis for the incentive plan.
  2. Determine the Plan Type. There is often considerable deliberation about the type of plan to deploy. Will a goal-based team plan provide your sales staff with a collaborative environment to motivate them to meet their sales objectives or will an individual production plan work better? How about a hybrid of the two? Identifying the approach that fits your culture and operating unit best will drive the right behavior.
  3. Simplify the Measures. Performance metrics will directly influence behavior. Should a commercial relationship manager be compensated for gathering deposits, increasing loan growth, referring mortgage customers, cross-selling wealth services, and doing so with the highest level of customer service? Well, yes. But should they be compensated for each of those measures or will individual measures for each slice unwittingly shift focus from the top priority goal? It is important to identify the most direct drivers of business success, while recognizing the potential impact of trying to cover too much ground.
  4. Calibrate Payout with Production. Understand the historical levels of production for your sales staff and the required output for the coming year, and align these expectations with appropriate payout opportunities. Are you willing to pay for breakthrough performance and if so, how much? What level of production are you not willing to pay for? And do these hurdles align with the revenue required to meet the business unit’s financial goals?
  5. Test for Risk. Do your own stress-testing to ensure the design will generally meet risk review tolerances before the plan is evaluated for risk. Ask the following questions: How much leverage is in the plan? Are the measures balanced and not placing too much emphasis in one area? Is there proper administrative and governance rigor? Does payout frequency align with the product life horizon? Are holdbacks or deferrals necessary in order to provide a means to adjust awards based on quality?
  6. Ensure Differentiation. The conservative nature of the industry often leads to final plan decisions that simply don’t provide for differentiated incentives, meaning there is not enough “pay daylight” between top and average performers. Providing meaningful differentiation is one of the principles behind well designed incentive plans—it will ensure your producers who lead the pack will be well compensated and highly motivated.

The potential impact to the bank if incentive plans underperform can be the difference between meeting and missing targets. Running through this checklist may help to identify enhancements that can optimize your plans and create a path to success.

What Compensation Committees Are Asking Right Now About Incentive Plans

9-26-14-pearl.pngAutumn is here and that means a busy season for compensation committees. They need to review the current year’s incentive plans and finalize those for the coming year. In the era of pay-for-performance, committees are feeling more pressure to ensure the right metrics are incorporated into the incentive plan framework, to set performance goals with an appropriate level of rigor, and to assess the plan’s response to performance. At Pearl Meyer & Partners, we have noted three questions frequently asked by compensation committees during the incentive planning process:

Our committee is wrestling with whether we have selected the right performance metrics for maximum effectiveness. What should we consider?
One of the first things to consider is whether the performance metrics within your incentive programs make sense in light of the bank’s current business strategy. If a new strategic plan has been developed or updated recently, do the current incentive metrics support the new strategy? How do your performance metrics work together as part of long- and short-term incentive plans to drive sustainable results? Choosing metrics that support the business strategy while also reflecting a balance of growth measures (i.e. loan/asset/deposit growth), earnings/returns (i.e. return on assets, return on equity, earnings per share, and total shareholder return), and quality/operational efficiency (i.e. non-performing assets, efficiency ratio) will help create a balanced incentive strategy. In times when higher growth outcomes could come with lower earnings and/or operational efficiency, it is important to achieve a balance among metrics in order to optimize shareholder returns.

We tend to set our incentive plan goals based on our budgets/forecasts. How can the committee evaluate the level of rigor represented by the goals?
Goal setting is one of the most challenging aspects of incentive plan design. It is common practice by many banks to use only the annual budget when setting target performance goals. However, committees are sometimes wary of this approach and can be concerned that management might manipulate the budget given that it is linked to the incentive plan. As a rule of thumb, the probability of achieving the threshold (minimum level of performance which must be achieved in order to earn an award), target and stretch goals (the target and maximum level of performance above which no additional award is earned) should be 70−80 percent, 50−60 percent, and 10−20 percent, respectively.

There are two ways to help measure probability:

  • The internal perspective examines the bank’s own historical performance. For example, you could look at the bank’s performance during the past five to eight years. How often in any given year did the bank achieve your current proposed goals? If the analysis indicates that the historical probability of achievement for the proposed target goal is 80 percent, then maybe the goal has been set too low and should instead be the threshold goal.
  • The external perspective examines the historical performance of peer institutions in order to determine their cumulative probability of achieving the proposed performance goals compared to the internal perspective. For example: the bank’s historical probability of achievement is 80 percent likelihood at threshold and 5 percent at the stretch goal. However, the peers’ historical probability of achievement is 60 percent at threshold and 40 percent at stretch. Since the bank’s spread is wider than peers, you may need to raise the threshold and lower the stretch goals.

Besides evaluating peer historical performance, committees can consider investor expectations by examining analyst estimates for various performance metrics and how they relate to the proposed goals. However, there is the potential for some circularity in this analysis given that analyst estimates often take into consideration management input regarding the bank’s expected performance.

How can we determine the right level of payouts in our incentive programs?
Many banks are re-examining and modifying incentive metrics and payout slopes to help find the proper balance between pay-for-performance and prudent risk management. Incentive payouts typically range from 50 percent of the target incentive payment at threshold to 125 or 150 percent of the target payment at maximum. An exception to this approach is with revenue-generating employees such as loan officers, who might get payouts up to 200 percent of target if they reach their stretch goals.

To validate, committees can examine peer practices in terms of the range of payouts. This might require analysis on a metric-by-metric basis. For example, net income may range from +/- 20 percent of target between threshold and stretch goals, but the range for the efficiency ratio will likely be narrower given it is a percentage metric.

For more information, watch a video of Kristine Oliver discussing the topic of Ensuring Dynamic Tension and Rigor Within Your Incentive Programs.