Key Compensation Issues in a Turbulent Market

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As compensation committee chair, Susan knew 2020 was going to be an important year for the bank.

The compensation and governance committee had taken on the topic of environmental, social and governance (ESG) for the coming year. They had conducted an audit and knew where their gaps were; Susan knew it was going take time to address all the shortfalls. Fortunately, the bank was performing well, the stock was moving in the right direction and they had just approved the 2020 incentive plans. All in all, she was looking forward to the year as she put her finished notes on the February committee meeting.

Two months later, Susan had longed for the “good old days” of February. With the speed and forcefulness that Covid-19 impacted the country, states and areas the bank served, February seemed like a lifetime ago. The bank had implemented the credit loss standard at the end of March — due to the impact of the unemployment assumptions, the CECL provision effectively wiped out the 2020 profitability. This was on top of the non-branch employees working from home, and the bank doing whatever it could to serve its customers through the Paycheck Protection Program.

Does this sound familiar to your bank? The whirlwind of 2020 has brought a focus on a number of issues, not the least of which is executive compensation. Specifically, how are your bank’s plans fairing in light of such monumental volatility? We will briefly review annual and long-term performance plans as well as a construct for how to evaluate these programs.

The degree to which a bank’s annual and long-term incentive (LTI) plans have been impacted by Covid-19 hinge primarily on two factors. First, how much are the plans based upon GAAP bottom-line profitability? Second, and primarily for LTI plans, how much are the performance-based goals based upon absolute versus relative performance?

In reviewing annual incentive plans, approximately 90% of banks use bottom-line earnings in their annual scorecards. For approximately 50% of firms, the bottom-line metrics represent a majority of their goals for their annual incentive plans. These banks’ 2020 scorecards are at risk; they are evaluating how to address their annual plan for 2020. Do they change their goals? Do they utilize a discretionary overlay? And what are the disclosure implications if they are public?

There is a similar story playing out for long-term incentive plans — with a twist. The question for LTI plans is how much are performance-based goals based upon absolute versus peer relative profitability metrics? Two banks can have the same size with the same performance, and one bank’s LTI plan can be fine and the other may have three years of LTI grants at risk of not vesting, due to their performance goals all being based on an absolute basis. In the banking industry, slightly more than 60% of firms use absolute goals in their LTI plans and therefore have a very real issue on their hands, given the overall impact of Covid-19.

Firms that are impacted by absolute goals for their LTI plans have to navigate a myriad level of accounting and SEC disclosure issues. At the same time, they have to address disclosure to ensure that institutional investors both understand and hopefully support any contemplated changes. Everyone needs to be “eyes wide open” with respect to any potential changes being contemplated.

As firms evaluate any potential changes to their executive performance plans, they need to focus on principles, process and patience. How do any potential changes reconcile to changes for the entire staff on compensation? How are the executives setting the tone with their compensation changes that will be disclosed, at least for public companies? How are they utilizing a “two touch” process with the compensation committee to ensure time for proper review and discourse? Are there any ESG concerns or implications, given its growing importance?

Firms will need patience to see the “big picture” with respect to any changes that are done for 2020 and what that may mean for 2021 compensation.

How Directors Get Paid: What to Know if You are on the Compensation Committee

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8-4-14-Blanchard-article.pngBank directors have experienced an increased workload in recent years with many new regulations and compliance guidelines. It is now more important than ever to ensure the total compensation program for your directors is competitive and linked to the bank’s overall compensation philosophy. In addition, it is important that your bank has an independent compensation committee that ensures that the compensation programs for both executive officers and directors are designed appropriately.

How Directors Get Paid
Once banks become profitable, they typically begin to pay cash fees to the board of directors to compensate them for the time they spend on board activities. Many banks have adopted a “pay-for-time” director compensation philosophy that is based on participation in board and committee meetings. These meeting fees can range from a couple hundred dollars to thousands of dollars per meeting with larger banks typically paying higher per meeting fees. Since the chairman of the board and the chairmen of committees typically spend more time preparing and presenting, these positions will often receive 20 percent to 30 percent more compensation per meeting than regular board or committee members.

In addition to per meeting fees, many banks use retainers in the form of cash to compensate directors. Retainers can be useful to attract directors in competitive markets when meeting fees may not provide enough to retain high quality professionals.

Paying Long-Term Incentives
Cash bonuses for directors are not considered a best practice in the banking industry. Best practices from the National Association of Corporate Directors state that the board should not receive compensation based on the achievement of annual performance metrics, as the board should be focused on making decisions for the long-term success of the bank. In place of annual cash-based incentives, the suggested incentive for the board is in the form of stock grants or cash-based deferred compensation programs such as phantom stock for private corporations, where compensation is given based on the bank’s long-term increase in book value. These types of long-term incentive plans have replaced or supplemented many of the cash retainer programs.

Paying Benefits to Directors
Director health and welfare programs are not common in the industry, as most insurance and retirement programs for directors are cost-prohibitive. A cost-effective benefit for directors is a voluntary deferred compensation plan where directors can defer their cash fees or retainers to retirement or an agreed upon date. The cost of these plans to the bank is any above-market interest rates applied to these types of deferred compensation programs, which typically makes this the most affordable benefit for bank directors.

The Importance of Compensation Committee Independence
Typically, the compensation committee is made up entirely of independent outside directors, which is now a requirement for publicly traded banks under the new Securities and Exchange Commission (SEC) compensation committee governance rules. These rules dictate that an independent director must not be an officer or employee of the company or its subsidiaries or any other individual having a relationship that, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

Hiring Independent Advisors
The SEC also is now requiring public banks to conduct an independence assessment of individuals who are advisers to the compensation committee. Prior to retaining or receiving the advice of any advisor, we believe all compensation committees should ask the following questions to assess independence:

  1. Does the advisor offer any other services to the bank that are paid by management?
  2. Are the amounts paid to the advisor a significant portion of the advisor group’s total revenue?
  3. Does the advisor have any business or personal relationship with a member of the compensation committee or an executive officer?
  4. Does the advisor own any stock of the company?

Director compensation programs are becoming more of a strategic focus in the banking industry as the workload and risk associated with being a bank director has increased. Also, there are more requirements now for the compensation committee to be aware of. It is more important than ever to ensure that the total compensation program for your directors is competitive and is in line with the compensation philosophy of the bank, and that the bank is following compensation rules. This will help ensure that the bank attracts and retains high quality directors to help direct the bank to future success.

Designing The Bank’s Incentive Plan

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12-6-13-Meridian.pngIncentive plans are a critical component of a bank’s compensation program. They help drive business results, provide competitive compensation opportunity and ensure an appropriate linkage between pay and performance. For publicly-traded banks, disclosure of incentive plans also serves as an important communication to shareholders of the bank’s priorities and commitment to pay-for-performance. With 2014 just around the corner, now is the time to determine the appropriate structure of your incentive plans for the new year.

Annual Incentives

Annual incentives help drive business results by linking compensation to the accomplishment of annual goals that support strategic priorities and ultimately create shareholder value. Key objectives of annual incentive plans include:

  • Driving business strategy – The choice of incentive measures and performance goals communicates to participants the results, behaviors and success factors needed to achieve business objectives. Banks should review their incentive plan measures each year to ensure they are aligned with the business plan and driving progress toward long-term goals.
  • Rewarding performance – Annual incentives should ensure that executives are appropriately rewarded for results. Plans should have threshold, target and maximum performance levels, with appropriate leverage in the payout ranges to ensure that reward levels are appropriate for the performance achieved (whether above or below expectations). Historical payouts should be assessed to determine if the plan is resulting in an appropriate pay-performance relationship.
  • Mitigating excessive risk taking – Bank regulators are focused on ensuring incentive plans, measures and payouts ensure participants are not incentivized to take excessive and/or inappropriate risks. This assessment should be conducted annually and whenever a new plan or changes are being proposed.

Choosing the right performance measures is essential to ensure that annual incentives support the key business objectives. While earnings (e.g., earnings per share, net income) is the primary focus for most bank annual incentive plans, including additional measures ensures a more balanced plan and provides the opportunity to directly link incentives to strategic priorities. Depending on a bank’s priorities, it may be appropriate to focus on growth, expense control, capital levels and/or credit quality.

It is also important to consider to what extent the annual incentive plan will reward performance at the company, business line and individual levels. Typically, a higher percentage of annual incentives are based on bank-wide results for senior executives to reinforce the team approach. Incentive plans also can provide some level of individual accountability by allocating goals specific to each executive’s role. Executives should meet to discuss their respective individual goals for the upcoming year to ensure appropriate coordination and interaction as needed.

Long-Term Incentives

Long-term incentive plans, which are typically delivered primarily through equity awards, should motivate and reward the creation of long-term shareholder value. Long-term incentive plans do this by enhancing alignment with shareholders, rewarding sustained long-term performance and creating retention “hooks” for high performers through the value of unvested awards.

Banks can choose from a variety of vehicles to deliver long-term incentives, including time-based restricted stock, stock options, performance shares (restricted stock that requires achievement of performance goals to vest) and long-term cash plans. Each vehicle has its own strengths and weaknesses in accomplishing the objectives of long-term incentive programs. Stock options and performance shares promote shareholder alignment and performance, while time vested restricted stock promotes stock ownership and retention goals. Most banks seek a balanced approach that allows them to achieve the multiple goals discussed above. As a result, an increasing number of banks are choosing a portfolio approach to long-term incentives, providing on average two components (e.g. stock options and time-based restricted stock or performance shares and time-based restricted stock).

For awards with performance vesting criteria, incentive measures should represent shareholder return or long-term value creation. Performance measures can be based on absolute results, relative comparisons to other banks or both. Absolute goals should align with a bank’s strategic plan. Relative measures avoid the challenge of multi-year internal goal setting, but require the selection of an appropriate comparative group of banks.

Conclusion

Given the significance of incentive plans, it is important to begin discussions about the design of programs well in advance of the new performance year. Banks should ensure that their programs support strategic objectives, motivate participants to drive the success of the bank and align pay outcomes with performance results. Annual evaluation of prior year results can also ensure plans are effective and provide input for realigning the plans if appropriate.