The Future of Executive Compensation

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.

Linking Long-Term Pay to Performance

applause.jpgIn an age when shareholders get an advisory vote on executive pay, there is an increased focus on pay-for-performance.  As a result, more banks are using long-term performance plans.  Unlike traditional restricted stock and stock option awards that vest solely over time, long-term performance plans also include pre-established performance goals that must be met for awards to be earned.

Meridian’s 2012 study of chief executive officer incentive plans at publicly traded banks with assets between $1 and $5 billion indicates that 34 percent include performance-based awards in their long-term incentive program, including more than half of the banks larger than $2 billion in the study. 

We anticipate the use of long-term performance plans will continue to increase. Shareholders and proxy advisors (such as Institutional Shareholder Services) typically respond positively to the implementation of long-term performance plans.  Additionally, well designed performance-based awards help provide balance and risk mitigation to incentive programs.  Many companies have used performance plans in their long-term incentive program to replace stock options, which regulators have discouraged as a riskier way to reward performance. Following are some of the key design elements to be considered in designing a long-term performance plan:

  • Award vehicle.  Banks predominately use full value shares (restricted stock or restricted stock units) in their long-term performance plans.  The number of shares ultimately awarded may vary based on different levels of achieved performance (e.g., threshold, target, and maximum).  While less common, programs can also be cash-based. 
  • Performance period.  Seventy-four percent of performance plans in Meridian’s study use three-year performance measurement periods.  Typically, three-year performance objectives are established at the beginning of the performance period, and awards are paid out based on actual performance at the end of the three-year period.  However, it can be challenging to establish appropriate three-year goals, particularly in an era of high economic uncertainty.  To avoid this challenge, some plans are structured for annual goals to be set each year of the three-year vesting period, while others only establish one-year goals but require additional service before awards are paid out.
  • Absolute and/or relative measurement.  Performance criteria can be absolute goals based on internal expectations, or they can evaluate performance relative to a peer group of companies.  Relative goals can make it easier to establish long-term performance goals, but provide less direct line-of-sight for executives and require a relevant group of companies to use for comparison.  Practices among banks in Meridian’s study are mixed—35 percent use absolute goals, 35 percent use relative goals, and 30 percent use a combination of both.
  • Performance measures.  Measures should tie to key corporate objectives that will drive long-term shareholder value.  Return measures (e.g., return on assets, return on equity) are most common among banks, followed by earnings measures such as earnings per share and net income.  Some banks measure shareholder value directly, tying payouts to the company’s total shareholder return ranking relative to a comparator group.  Most banks use two or three performance measures in their plans.
  • Mix and match.  While performance plans can be a critical part of a bank’s long-term incentive program, they may not meet all of the program’s objectives.  Performance plans are often used in combination with time-based equity grants (e.g., stock options and restricted stock) to provide a balanced program and limit compensation risk.  In most cases, the performance plans are used to deliver 50 percent or more of the target long-term incentive value for senior executives, but are often combined with other award vehicles such as time-based restricted stock.

Several other items must also be considered when designing a long-term performance plan, including: Who will be eligible, how will it be disclosed, what is the accounting expense, what are the tax consequences, and will shareholders approve of the plan? While performance-based long-term incentives require many decisions, they can enhance pay-for-performance and create a balance between short-term and long-term objectives.  Banks that do not currently have long-term performance plans should consider whether introducing one would improve the effectiveness of their executive compensation program.