Deciding on the Right Retirement Plan for Executives

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9-19-14-Equias.pngBanks are challenged to attract and retain both key executives and key producers. While cash compensation plays a major role in this process, many community banks use nonqualified benefit plans, which provide supplemental retirement income as an attractive recruiting and retention tool.

According to the American Bankers Association’s 2013 Compensation and Benefits Survey, 64 percent of banks offer some type of nonqualified deferred compensation plan. These plans are limited to select management or highly compensated employees. Nonqualified plans are generally categorized as either defined benefit plans or defined contribution plans.

With different types of nonqualified plans available, how do you decide which plan your bank should provide?

In a typical defined benefit plan, the executive is promised a fixed dollar amount or percentage of final pay at retirement as the plan is designed to overcome a retirement shortfall or achieve a specific wage replacement ratio. The executive receives a stated amount (e.g. $50,000 per year) for a stated period of time (e.g. 15 years) beginning at separation from service, or a specified date or age.

Defined contribution plans vary in design. The executive’s deferred compensation balance might consist of all bank contributions, all executive contributions, or a combination of the two. Bank contributions might be predefined, such as a specific dollar amount or percentage of salary each month, or they may vary based on achievement of certain performance goals (often called performance-driven retirement plans). The deferral or contribution is credited with interest by the bank and the accrued amount is paid beginning at separation from service or a specified date or age.

On the surface, it may seem that the performance-driven designs provide more alignment of the executive and shareholder interests; however, that may not be the case for the following reasons:

  1. Executives generally prefer defined benefit plans over performance-driven plans. The defined benefit plans provide a base level of retirement income to supplement the variable/uncertain amount of retirement income from the executive’s 401(k) plan and stock awards. The executive may favor the employer that offers the defined benefit SERP and may be willing to take a lower retirement benefit because of the higher degree of certainty.
  2. Once implemented, properly designed defined benefit plans are easy to administer and the expense can be budgeted for years to come.

Both benefit plan types require various terms and conditions to be documented in a contract between the bank and the executive. The contract should provide strong retention hooks, as described in a recent Bank Director article.

A couple of recent examples will help illustrate the board’s rationale for the implementation of both types of SERP:

Defined Benefit
Bank A conducted a nationwide search to hire a CEO. As part of the CEO’s compensation package, the board of directors agreed to provide a SERP designed to replace 70 percent of his final compensation, after taking into consideration his 401(k) and social security benefits. The board considered various alternatives but believed the defined benefit SERP was the most effective method to achieve its objective. Since the executive was only 50 years old, he would earn the SERP over the next 15 years. The executive was incentivized to take the position, in part, because of the promise of a stable retirement income, which would allow him to focus his energy on bank performance. In addition, the executive was provided with restricted stock that would provide alignment of the executive’s and shareholders’ interests. Lastly, the board favored the stability of expense the defined benefit SERP provides and the fact that the design does not promote excessive risk-taking.

Performance Driven
At Bank B, the board felt strongly that supplemental executive retirement benefits should be provided using a performance-driven design. The board believed that to maintain a high-performance culture that aligns management and shareholder interests over the long-term, a defined contribution approach was the best fit. The plan provided that annual contributions would be measured based on performance targets established by the board. To provide additional protection against excessive risk-taking, the benefit payments would not begin until age 65 and would be payable in monthly installments over a 10-year period. All benefits would be forfeited if the executive was terminated for cause, if there was a material misstatement of the financial statements, or if the executive competed with the bank after termination of employment.  

Summary
There is no one size fits all approach with regard to nonqualified benefit design. The facts and circumstances of the case, including bank culture and objectives, will dictate the best design for any given bank and executive. For more information on this topic, please see: “Is Your Compensation Plan Generous Enough?”

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

Designing the Pay-For-Performance SERP: Executive Retirement Plans Transformed

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12-20-13-iZale.pngAttracting and retaining the most talented senior executives are key responsibilities of the bank board. But how do you do that, especially in an age where compensation programs are changing and there is more pressure on bank boards to design compensation programs that reward performance?

For key employees, one of the more popular ways to provide wealth accumulation opportunities is through a nonqualified deferred compensation plan, more specifically a Supplemental Executive Retirement Plan or SERP. Traditionally, SERPs have been defined benefit (DB) plans, where the bank promises to pay a fixed dollar amount (e.g., $50,000 per year) or a percentage of compensation (e.g., 25 percent of final average salary) during retirement. Defined benefit SERPs offer the highest attraction and reward value, and are often used to address the disparity between key and rank-and-file employees. (Typically, rank-and-file employees have a greater percentage of their income replaced in retirement than executives using traditional retirement plans.)

Accounting rules dictate how the bank should expense and accrue for the benefit. If the participant remains employed by the bank until retirement, the benefit will be paid. Defined benefit SERPs are not tied directly to bank performance, and this has led to some criticism and resistance to implementing them.

As a result, performance-based SERPs are increasingly being considered. With a performance-based SERP, an annual award is based on attainment of pre-defined goals. In other words, it’s a defined contribution or DC SERP. Since participants are usually senior executives, the DC SERP goals are typically bank-wide instead of individualized goals. They can be the same goals used for determining short-term incentives; in fact, there is administrative ease in such goal consistency. Unlike the annual incentive that is paid out now, however, each DC SERP award is deferred until retirement. Over the life of the plan, the awards accumulate and are distributed at retirement.

From an accounting perspective, DC SERP modeling is more complicated than DB SERP modeling but is built on the same principles. Under a DC SERP, if a 50-year old participant receives an award of $50,000 to be paid in installments beginning at age 65, GAAP (Generally Accepted Accounting Principles) requires the bank to expense the award at its net present value, and thereafter increase the balance sheet amount each year until retirement. Subsequent awards go through the same process—picture stacking Legos.

Boards should recognize that DC SERPs can result in greater benefits to the participants than a DB SERP. When properly designed, if a high-performing bank continuously achieves its goals, the cumulative DC SERP awards should be greater. It may also be desirable to have both a DB SERP and a DC SERP.

The normal expected retirement benefit is where most of the focus is, as that is what drives everyday accounting. However, proper SERP design requires consideration of other events that trigger distribution. The question for each trigger is what—if any—benefit should be paid.

  • Early voluntary termination. This is when the participant leaves employment before normal retirement age. Often there is no benefit, or there are several years of participation before any benefit begins to vest.
  • Early involuntary termination. Here, the participant is terminated by the bank without cause, or for defined “good reasons.” Often, there is some vesting immediately, whether in just the accrued benefit or some accelerated amount.
  • Disability. The participant suffers illness or injury that results in termination or meets the definition of Disability in IRC Section 409A. Typically, there is 100 percent immediate vesting in either the accrued benefit or some accelerated amount.
  • Change in control. When an acquisition takes place, the transaction is usually one trigger, and the participant’s termination of employment is a second trigger. Should one or both triggers be required for a payout to occur? Should the second trigger be voluntary or involuntary? Typically, there is some vesting immediately, but the amounts can vary significantly. Change in control benefits should be carefully considered, as there are Internal Revenue Code provisions that could tax these benefits heavily and impact a company’s ability to deduct them.
  • Death. Should the accrued benefit be paid, or some higher amount?

The board should understand the potential maximum payout and the impact on the bank’s income statement and balance sheet for each trigger, especially those that accelerate the amount compared to what has been accrued. Disability and death events can be insured; others cannot.

SERP design is both art and science. While the science is the same for all, working with an experienced vendor will make the art reflect your bank’s objectives.