Regulators Revive Efforts to Pass Dormant Compensation Rules

When it comes to incentive compensation, everything old is new again.

Financial regulators are expected to revive rulemaking on a number of compensation provisions that never went into effect but were mandated by the Dodd-Frank Act of 2010.

Some of the issues that bank and securities regulators could consider in the coming quarters include measures that will gauge executive pay against their performance, as well as mandate clawback provisions and enhanced reporting around incentive compensation structures, said Todd Leone, a partner and global head of compensation at consulting firm McLagan. He was speaking during Bank Director’s 2021 Bank Compensation & Talent Conference, held Nov. 8 to Nov. 10 in Dallas.

All banks with more than $1 billion in assets would need to comply with the final version of the enhanced incentive compensation requirements. Public companies, including banks, would need to comply with any final rules around clawbacks and pay versus performance. If the topics sound familiar, Leone reminded the crowd, it was because they were debated when the banking reform bill initially passed in 2010. Regulators considered rulemaking several years later. But the move to finally pass those rules could catch banks off-guard, especially when considering that rulemaking was essentially paused under the administration of President Donald Trump. Below is Leone’s overview of the proposed rules.

Clawback provisions, or a company’s ability to take back previously awarded pay or bonuses after a triggering event such as a restatement of earnings, were a hotly debated topic of the post-crisis financial reform bill more than a decade ago. They also came into focus in the bank space after news broke about the Wells Fargo & Co. fake account scandal in late 2016. In 2017, the bank’s board announced it would seek $75 million in previously awarded compensation from two of the senior executives that it held accountable for the scandal. In response, a number of banks created clawback policies of their own.

In October 2021, the U.S. Securities and Exchange Commission, under Chair Gary Gensler, reopened the comment period for the clawback provision, or Section 954 of the act. Leone pointed out that the proposed rule defines a triggering event as an accounting restatement for a material error. A company has up to three years to claw back incentive pay linked to the financial information that is restated; potentially impacted employees include current or former executive officers. Leone expected a final rule by the second half of 2022 but recommended that audience members stand pat until something is published.

“Don’t touch existing policies, since it’s in flux,” he recommended for banks that created their own policies.

Pay For Performance
Pay for performance, or Section 953(a), is a proposed disclosure requirement for public companies, including banks, that would most likely appear as a table in the proxy statement. The disclosure compares total shareholder return for a company against a company-selected peer group, along with compensation figures of a company’s top executives. The company would need to state the principal executive’s reported total compensation for the current year and past four years, along with the average reported total compensation for other named executive officers over the current year and past four years.

Like the clawback proposal, this provision was first debated by the SEC in 2015; it is in “final rule stage,” according to the agency, and Leone believed it could go into effect in the second half of 2022. The rule could create a “fair bit more work” for companies to comply with, he said. But he believed it will have a similar impact on the industry as the CEO pay ratio disclosure, which compares the pay of the CEO to that of the company’s median employee and has yet to lead to significant changes in pay for either group.

Incentive Compensation Rules
Similar to the other two proposals, the enhanced incentive compensation rule, or Section 956, has come up again. The SEC included it as a proposed rule in its agency rules list for spring 2021. Leone joked that he had used the same presentation slide on the enhanced incentive compensation rule a decade ago. The rule has been proposed by regulators twice since the passage of Dodd-Frank: It was 70 pages when it was first proposed in 2011 but had grown to 700 pages when it was re-proposed in 2016, he said.

Leone believed this rule will come up again in the spring of 2022, and that rulemaking will take some time because a number of regulators will need to collaborate on it. It would apply to all banks with more than $1 billion in assets, along with other financial institutions such as credit unions and broker dealers. The requirements would vary based on asset size, with the biggest firms facing the most stringent rules around their incentive compensation agreements. Under previous iterations of the rule, financial institutions would need to include provisions to adjust incentive compensation downward under certain circumstances, outline when deferred incentive compensation could be forfeited and build in a clawback period of seven years.

In the end, Leone recommends banks be proactive when it comes to changing compensation rules.

Expect more, not less regulation,” he said.

2019 Survey Results: CEO and Board Pay Trends

Today, more banks are tying their chief executive officers’ pay to performance indicators, as indicated by 80 percent of the directors and executives responding to Bank Director’s 2019 Compensation Survey, sponsored by Compensation Advisors. That’s up from 75 percent when Bank Director last posed the question, in 2015.

Most, at 59 percent, tie CEO compensation to their strategic plan or corporate goals.

But the metrics banks prefer vary according to their structure. Public banks are more apt to tie pay to performance—just 8 percent indicate they don’t do so—and tend to favor goals established in the strategic plan (72 percent), as well as metrics such as return on assets (58 percent), return on equity (53 percent) and efficiency (40 percent).

Among private banks, net income is the preferred metric, at 55 percent. Twenty-seven percent of respondents in this group say CEO compensation is not tied to performance.

The survey was conducted in April 2019, and includes the perspectives of more than 300 bank directors and executives—including chief executives and human resources officers—as well as data obtained from the proxy statements of more than 100 publicly traded banks.

It includes details about current CEO and director compensation packages—in the aggregate, and by asset size and ownership structure. The survey also focuses on succession planning and board refreshment.

Respondents indicate that their CEOs all received a salary in fiscal year 2018, at a median of $325,000; the median total compensation was $515,728. Paying a cash incentive (78 percent), and offering benefits and perks (75 percent) are also common forms of compensation throughout the industry. Less common are nonqualified deferred compensation or retirement benefits (49 percent) and equity grants (47 percent). However, payment of equity differs broadly based on the ownership of the bank: Almost three-quarters of respondents from public banks say their CEO received an equity grant last year.

Additional Findings

  • When asked how compensation for the CEO could be improved, 36 percent point to offering non-equity, long-term incentive compensation. Twenty-three percent believe the bank should offer equity at greater levels, and 21 percent say they should offer some form of ownership in the bank. Twenty-two percent believe the bank should pay a higher salary to the CEO.
  • The median age of a bank CEO is 58. Seventy percent are baby boomers, between the ages of 55 and 73.
  • Seventy-two percent believe the current CEO will remain at their bank for at least the next two years.
  • Twenty-one percent believe it’s time for their CEO to announce his or her retirement.
  • Thirty-one percent say their bank has designated a successor for the CEO. One-quarter have identified potential successors.
  • Nearly one-third indicate their board conducts an annual evaluation.
  • Forty-one percent have a mandatory retirement policy in place for directors. The median retirement age is 75—an increase from 72, as reported three years ago.
  • Forty-seven percent indicate their board is working to recruit younger directors. The median age of the youngest director serving on responding boards is 48.
  • Seventy-two percent say their directors receive a board meeting fee, at a median of $900 per meeting. Sixty-nine percent pay an annual cash retainer, at a median of $20,000.
  • Forty-three percent say that tying compensation to performance is a top compensation challenge facing their institution, followed by managing compensation and benefit costs (37 percent) and recruiting commercial lenders (36 percent).

To view the full results of the survey, click here.

What’s Changed in Executive Compensation Since the Crisis

compensation-3-4-19.pngA decade ago we were in the middle of an economic downturn and the world of executive compensation was under intense scrutiny.

One target for that scrutiny was executive benefits and perquisites. Things like excessive change-in-control payouts with “gross-ups” and perquisites like vehicle allowances and country club memberships were placed under the microscope.

Executive perquisite policies were put in place, and additional focus was placed on the SEC proxy statement disclosures of perquisites in the Summary Compensation Table when the aggregate amount exceeds $10,000.

To track the impact of these changes, Blanchard Consulting Group has conducted a benefits and perquisites survey three times over the last 10-year period. The most recent survey was completed in early 2019.

Here are three key areas:

Change-In-Control Agreements & Gross-Ups
The prevalence of CIC agreements has been consistently between 50 and 60 percent each time we have conducted our survey, so there has really been no change in the market surrounding who has these provisions in place. For additional reference, our public bank database indicates this segment is slightly above 80 percent prevalence for CIC agreements and this hasn’t changed much either in recent years.

What about severance multiples paid? Consistently, the most common response (around 35 percent) is the multiple for CEOs has been between 2 and 2.5 times salary or cash compensation.

So how about the “gross-up” clauses that added pay to the executive severance package if their payout was deemed excessive for Section 280G of the tax code? Our research only shows a slight decrease in the prevalence of these clauses. About 25 percent of the sample indicated they had them when we first conducted the survey and now we are just below 20 percent of the sample.

In summary, not much has changed surrounding CIC agreements and “gross-up” clauses.

Supplemental Retirement Plans
The existence of supplemental executive retirement plans (SERPs) or salary continuation agreements (SCPs) have declined from 53 percent in 2011 to 47 percent in 2018, which is not a lot of movement. Prevalence of these plans at public banks has hovered around 45 percent.

What about the benefit amounts being paid under these plans? Not much has changed here either. Around 70 percent of CEOs with defined benefit amounts are targeting something below 55 percent of final compensation, which is the same in 2018 versus 2011.

Supplemental retirement plans have not experienced much change in the banking market either.

Executive perquisites have not changed much surrounding car allowances or country club, hovering around 70 percent prevalence. This is very similar to the numbers back in 2011. In fact, the percentage of banks who do not offer any perquisites to their executives has only dropped a couple of percentage points, from 12 percent to 8 percent.

So once again, not much has really shifted or changed in the world of executive perquisites either.

So what should we make of the fact that there appears to be no significant adjustment, “scale-down,” or elimination of executive benefits and perquisites in the last 10 years? Did regional and community banks simply ignore the government-focused initiatives?

Some might say yes, but there’s another argument to be made.

It’s possible that community and regional banks were simply never paying their executives inappropriately or excessively. The compensation designs in place at those institutions were market-based, competitive, and reasonable. During the downturn many executives experienced salary freezes and either zero or minimal cash bonuses as bank performance dropped.

This was appropriate under pay-for-performance incentive plan designs. Since that time, compensation has increased as bank performance has increased and not much has changed in the world of executive benefits and perquisites.

These benefits and perquisites were reasonable then and are still reasonable now in the eyes of the decision-makers at community and regional banks.

Keeping Pace with Wages After Corporate Tax Cuts

compensation-4-12-18.pngSince the reduction of the corporate tax rate from 35 to 21 percent, 64 banks nationwide have raised their minimum salaries to $15 per hour or given bonuses that range from $500-1,500, or both.

This number has increased by 50 percent since Jan. 1. Some have increased their 401(k) matching contributions. Some have made significant donations to nonprofit organizations in their communities.

Companies in the market at-large with whom financial institutions often compete for frontline talent are increasing their starting wage. For example, Target has announced it will raise its salaries to $15 per hour by 2020. Apple has announced it will reinvest $350 billion and add 20,000 jobs in the U.S. over the next five years. Companies with freed up capital are investing in the war for talent and in their communities.

All of this has caused concern for community banks and credit unions as they wrestle with whether they should follow suit and raise pay to $15 an hour. Here are our suggestions:

  • Know the market rate for wages. This requires examining external data and internal equity by a professional who is not bound to internal politics and long-term relationships between incumbents. You may need a midpoint that is 10 percent above the market as a competitive advantage.
  • Have a compensation philosophy and salary administration guidelines. Audit against those standards for consistency. If the next administration reduces the tax advantage, you would not need a knee-jerk reaction to adjust.
  • Don’t overpay for inexperienced new hires. We strongly recommend new employees with little or no background receive a starting salary of approximately 85 percent of the midpoint for most jobs and 90 percent of midpoint for “hot jobs.”
  • Develop a salary increase process that ensures that pay levels are getting to their midpoint in a reasonable period of time. Non-exempt employees with three years of experience in their job would have a pay level at 100 percent of the midpoint. Exempt employees with five years of experience in their job would get to their midpoint in five years. (This is where most salary administration programs fall down.)
  • Pay for Performance. The average salary increase differential by performance is 2 percent. If the difference between a high performer and an average performer is 1 percent, you are not differentiating the salary increase significantly enough to “pay for performance.”

When I review the pay levels of clients that have contacted us about an appropriate response to the market, it is easily to determine they were inconsistently applying their own salary administration guidelines. This should have been an obvious step even before the tax cut incented companies to offer more competitive pay.

If your competitive advantage is your people, then the war for talent is growing more heated. Have a well thought out compensation plan. Get out of the guessing game. Live up to your plan consistently. Update your salary ranges annually. Reevaluate and commit to your compensation strategies.

Playing Your Cards Right With Executive Compensation Disclosures

proxy-season-11-13-15.pngAs the 2015 calendar gets shorter, are you hedging bets that your next Compensation Discussion & Analysis (CD&A) will wow shareholders and ensure a strong say-on-pay vote next year? Or are you hoping to bluff your way through the next proxy season? Between regulatory changes and a high level of public scrutiny, it’s never too early to begin focusing on your executive compensation disclosures. 

Why Communication Strategy Matters More Than Ever
Effectively communicating your compensation plan and its link to the bank’s business and leadership strategies is a growing priority among boards and management teams. As we all know, executive compensation—and the regulation surrounding it—is increasingly complex. A well-planned and artfully delivered disclosure document can improve chances of a favorable say-on-pay outcome and potentially bolster your defenses against shareholder activism. At a minimum, it can help improve overall shareholder engagement and build communication between the board, management and other stakeholders.

The Ante: Emerging Compliance Requirements
Unfortunately, the Dodd-Frank Act’s many provisions are still looming and it’s only a question of time before the final proposals on matters such as the CEO pay ratio, pay-for-performance, and clawbacks are implemented. These fast-changing rules can make it difficult to keep up from a communication perspective. How might these new mandates complicate or conflict with your compensation strategy and how can a public bank ensure they’re fully compliant, while delivering the most effective story to shareholders and employees about the executive pay programs?

Remember—balance is the key. With so many requirements coming, it will be necessary to offset the potential complication of your message with clear details on your compensation design and its alignment with the bank’s business strategy. Within the regulatory context, there’s an opportunity to discuss:

  • How executive compensation supports your business strategy and leadership talent goals;
  • How compensation is defined;
  • How performance is viewed;
  • How sound governance and risk management is practiced; and
  • What you pay your executives and why.

It’s not just public banks that face these issues. While private entities aren’t required to disclose, many feel the resulting public pressure to communicate more and can benefit from the following guidelines.

The Winning Hand: Moving Beyond Compliance to Tell Your Story
Obviously, compliance is important, but companies need to continue shifting program design focus from compliance to a compensation philosophy that supports the long-term business strategy.

Results from Pearl Meyer’s 2015 OnPoint Survey: The New Normal of Annual Compensation Disclosure, offer several points to consider as you begin the CD&A development process. Perhaps most surprising is that ”reader-friendliness” of the CD&A is just as important to compensation committees as technical accuracy. In fact, making the content easier to read/understand ranked as the number one request compensation committees make to staff regarding the CD&A. Survey results also indicate those companies who rate their CD&A as “excellent” or “very good” experience a higher percentage of yes votes for say-on-pay from shareholders than companies who don’t rate their CD&A as high.

There are three ways to ensure you “win the hand” in regards to your pay communications to shareholders:

  1. Take advantage of emerging trends for content and design.  There have been big changes over the past five years in how information about pay is presented within the CD&A. Content needs to be accurate, complete and concise while keeping in mind that shareholders are the target audience. Incorporating elements such as executive summaries and visuals that illustrate year-over-year pay levels, mix of variable versus fixed pay, and realizable/realized pay help organize the story and pull the reader through the document. The survey results show a clear pattern: companies with favorable views of their communication use these methods far more than companies who believe their CD&A is only fair or needs improvement.
  2. Leverage the experts to develop and deploy your message. Using internal corporate communications practitioners, graphic designers, and external writers can be worth the expense. Survey results show that companies who have relied on communication experts to help develop content typically have excellent or very good communication effectiveness and almost 80 percent of these companies are using at least one professional resource.
  3. Adjust your timeframe. The quality of executive compensation disclosure is more important today than ever and the quantity of information required is growing. Therefore, it it’s never too early to get started! Our survey confirmed that those who began working on their disclosures before the close of the fiscal year reported excellent or very good communication effectiveness. It’s a safe bet to follow their lead.

Taking this disciplined approach to communicating the value of your programs should pay off in the long-term and can help your board successfully move ahead with strategy-based design.

Aligning Pay with Long-Term Strategy

2014-Compensation-Survey-White-Paper.pngWhile bank boards recognize the need to tie compensation to the performance of the bank in the long term, they continue to struggle with how to get the pieces in place to attract and reward the best leaders to meet the institution’s strategic goals. Many of the directors and senior executives that responded to Bank Director’s 2014 Compensation Survey, sponsored by Meyer-Chatfield Compensation Advisors, confirm that getting pay for performance right continues to challenge their boards. Less than half tie CEO pay to the strategic plan or corporate goals, and more than one-quarter of respondents say that CEO compensation is not linked to the performance of the bank. Flynt Gallagher, president of Meyer-Chatfield Compensation Advisors, says that boards should always keep the strategic plan and long-term goals in mind when determining compensation for executives, but many boards aren’t specific about the goals and objectives they expect the top executives of the bank to achieve.

Meyer-Chatfield Compensation Advisors offers the following advice for boards based on the results of the survey:

  • Executive performance goals should be clearly defined and tied to the bank’s strategic plan.
  • Make sure the bank is planning for the future and has a succession plan in place. Forty-two percent of executive hires were driven by executive departures in 2013.
  • Competitive pay is critical to attract and retain key talent, but it is not the determining factor. Culture can be the intangible that drives talent to—and from—an organization.
  • The board must determine its own pay—not the CEO.
  • Evaluate whether the board’s pay is fair and aligns with market practices.

For more on these considerations, read the white paper.

To view the full results to the survey, click here.

Four Topics to Add to Your Summer Compensation Committee Agenda

7-16-14-article.pngProxy season has recently ended, and the beginning of the third quarter marks the start of a new compensation planning season. The summer meeting of a bank’s compensation committee is an ideal opportunity to reflect on the previous compensation cycle and to consider the next—often by focusing on topics like proxy season trends, pending regulatory/legislative and other emerging compensation issues. However, the summer committee meeting can also be used to focus on issues of more strategic importance to the bank. Consider adding one or more of the following topics to your summer discussions to increase your committee’s effectiveness over the upcoming year.

  1. Succession Planning
    Our experience in working with community banks is that many board members do not view succession planning as a high priority issue. They either don’t view retention of their CEO as a risk, and/or their CEO is still several years away from retirement. As a consequence, many directors cannot articulate what would occur if a CEO’s departure, death or disability left the bank suddenly leaderless.

    Considering that it takes several years to develop and cultivate a CEO successor in the best circumstances, boards should identify potential candidates to succeed the CEO long before he or she retires. High-potential executives are always in demand, and developing your bench will strengthen the team and mitigate the risks associated with unexpected and unwanted executive turnover.

    And even if long-term cultivation of candidates is less of a priority right now, an emergency CEO succession plan should be a requirement for all organizations, to mitigate the business continuity risk should tragedy strike. An emergency CEO succession plan will minimize board deliberations and discussions of interim CEO candidates in crisis situations by articulating a structured process (the timing of internal and external communications and board decisions), as well identifying one or more interim CEO candidates (who could come from the senior leadership ranks or the board).

  2. Pay-for-Performance Analysis
    The most common pay-for-performance analysis retrospectively evaluates historical financial performance and total shareholder return relative to actual compensation received by the CEO (and potentially other proxy executives), compared against the performance and pay of peer companies. Simply put: did the incentive programs deliver appropriate pay for the performance results achieved?

    Summer is an effective time to discuss these pay-for-performance results with the committee, since pay data for peers is publicly available following the end of proxy season. The results may encourage further discussions about the organization’s compensation philosophy, and especially the effectiveness of incentive plans in supporting your business strategy and results.

  3. Compensation Philosophy and Peer Group
    Wholesale changes in compensation philosophy from one year to the next are rare, but as your bank’s business strategy evolves, your compensation philosophy ideally will evolve as well. For example, as a business strategy evolves from growth to profitability (or vice versa), the corresponding compensation philosophy should consider re-weighting incentive plan metrics to more effectively support such a change in priorities.

    Peer group changes are less frequent in banking than in other industries, but your peer group may require re-evaluation if the bank has grown significantly, or changed business focus (for example, geographic footprint, or retail vs. commercial lending). Likewise, continued industry shifts (mergers, business shifts, etc.) require an annual review to ensure that peers are still a good “fit” with the bank.

  4. Committee Meeting Calendar and Agenda
    A compensation committee’s summer meeting tends to include fewer time-sensitive items than most other meetings. It is an ideal time to review your annual committee meeting calendar and standing agenda items relative to the committee charter. Work collaboratively with your executive team and outside advisors to ensure that no key issues are overlooked, and that items are spaced throughout the year to allow enough time for consideration of relevant information and thoughtful deliberation prior to key decisions.

Remember that the purpose of your executive pay programs is to support and reinforce your bank’s business strategy. Proactive planning of your meeting calendar and agenda will ensure your committee is addressing all its compliance-related requirements, while allowing sufficient time to thoughtfully consider strategic implications of compensation design decisions.

To find a full year’s Compensation Committee agenda items for community banks in our recently published document, Managing an Effective Compensation Committee Calendar for Community Banks, go here.

Now is the Time to Test and Report Your Pay and Performance Relationship

2-14-14-Meridian.pngCreating alignment between pay and performance is critical in today’s environment of executive pay scrutiny. However, understanding how to assess the relationship and communicate it effectively can be challenging. There are many different methodologies and perspectives that should be considered. Following are several important considerations for testing and reporting the alignment between executive compensation and performance.

Testing the Relationship

Assessing the relationship between pay and performance requires establishing methodologies for calculating pay and evaluating performance, as well as determining the time period to analyze.

The most traditional view for reviewing the pay and performance relationship reflects actual compensation granted, which includes base salary, annual incentive paid and grant date value of long-term incentives. While this is consistent with proxy reported information, it does not reflect actual pay received nor a full picture of performance.

We believe multi-year analyses (e.g. over three and five years) that focus on actual value of compensation earned provides a broader perspective on the effectiveness of executive compensation over time. There are two primary alternative views of pay that companies are considering:

  • Realized compensation focuses on the actual value received by executives, comparable to their W-2 income. It includes long-term incentives that are realized, such as restricted stock that vests and the value of exercised options.
  • Realizable compensation assesses the current value of compensation awarded during the time period, whether it has been realized or remains outstanding. Long-term incentives are valued based on the current stock price, with stock options included based on their in-the-money value.

Each methodology has advantages and disadvantages. While actual compensation reflects the committee’s decisions, it does not consider that the value received by the executive will be based on the ultimate value of long-term incentives, which may be driven by stock price and have additional performance hurdles. Realized compensation emphasizes the value actually received by executives, but are influenced by awards granted before the beginning of the performance time period or by timing decisions of the executive, such as the exercise of stock options. Realizable compensation attempts to focus on the value of compensation granted and earned during the performance period, but may require challenging assumptions when long-term performance plans are included.

Reporting Pay for Performance

A key responsibility of the compensation committee, whether public or private, is to test and ensure proper pay-performance alignment annually and over multiple years. The committee should oversee the selection of the peer/reference group, approve the performance measures used in the pay program and analyze how pay (awarded, realized and realizable) aligns with performance over defined periods of time. Graphs and charts can be an effective way to illustrate trends. For example, how has pay tracked against total shareholder return, return on assets and earnings relative to the company’s own internal goals as well as an industry/peer group? Results provide direction as to whether there is alignment between pay and performance or possible deficiencies in the pay program. For example, if a company regularly misses internal budget goals but exceeds peer performance that might indicate stretch goals that may not be achievable. Likewise, if incentive plans are consistently missing thresholds or hitting stretch, that may be an indication of misalignment of goal setting.

While the Dodd-Frank Act required the Securities and Exchange Commission (SEC) to develop rules for companies to disclose the relationship between executive compensation actually paid and financial performance, the SEC has yet to develop proposed rules. However, many companies have started disclosing this in the compensation discussion and analysis of their proxy reports. Likewise, proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis & Co. have their own methodologies for evaluating pay and performance when they develop recommendations for the annual say-on-pay votes required of public companies. For example, ISS looks at the relationship between CEO total compensation and three- year total shareholder return compared to peers and the company’s own five-year total shareholder return. Where their methodology identifies a disconnect, the proxy firms may recommend shareholders vote “against” the pay package. Although it is an advisory vote, it is important for company management and compensation committees to understand the influence of these firms and the potential consequences of a negative vote, which can bring lawsuits and public scrutiny.

Even though the SEC has not yet required a pay-for-performance disclosure, public companies may want to consider whether any disclosure based on the perspectives described above would be useful in their proxies. Whether or not disclosed publicly, all compensation committees should evaluate whether their bank’s programs are creating pay-for-performance disconnects and determine if program changes are needed.

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

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.

The Changing Landscape for Incentive Pay

10-25-13-Blanchard.pngHistorically, bank employees have enjoyed a culture where employees had a feeling of entitlement to generous annual salary increases and profit-sharing bonuses merely for continuing to work for the bank. That is changing. Performance based cultures that reward shareholders and employees and allow transparent communication of expectations and results are becoming more prevalent.

Creating compensation plans that provide a transparent link between actual organizational performance and executive pay is now the rule rather than the exception. Several aspects of the Dodd-Frank Act encourage pay for performance, including mandatory clawbacks of unearned compensation, transparency of incentive compensation agreements and shareholder say-on-pay advisory votes. The increasing influence of shareholder advisory groups (primarily Institutional Shareholder Services and Glass-Lewis) have driven public banks to change executive compensation practices to reflect pay for performance.

Private banks also are shifting executive compensation practices as their regulators look for best practices in executive compensation. Blanchard Consulting Group’s 2012 Executive Benefits Survey showed that 59 percent of banks said regulators reviewed executive compensation plans and practices during the exam. Blanchard Consulting Group’s 2013 Compensation Trends survey found that 63 percent of banks have modified executive compensation incentive plans in at least one of the last three years based on the changing bank regulations.

Compensation transparency at the executive level as well as emphasis on cost containment (salary and benefits costs are generally the largest budget expenditure for a bank) are supporting a larger overall bank cultural shift away from “pay for loyalty.”

Creating a Performance Based Culture

What can your bank do to start to support a sales and performance based culture? Creating a bank-wide annual incentive plan (AIP) with individual employee goals that “roll-up” to the executive AIP goals is one alternative. For example, in the lending department, all the loan officers’ portfolio loan growth goals at target performance levels should add up to the overall bank target loan growth goal. Your bank can also affect change with strategic use of the annual salary increase budget. For example, your bank may target a 3 percent salary increase for all employees. Instead of just giving all employees a 3 percent increase, many banks are now using position on a salary range and performance reviews to give more of a salary increase to high performing employees or those that are meeting performance expectations and are low on the salary range. There is an opportunity for strategic salary budget use, especially with the recent economic hardship that certainly broke down employee entitlement thinking around salary increases. Many banks froze salary increases or bonuses or both during 2008 to 2010. This practice as well as bank failures, mergers and acquisition activity, reduction in force, and hiring freezes gave employees a clearer sense of how their pay and job security is affected by overall bank performance.

Impact on Executive Officer, Producer and Staff Level Incentive Plans

Both executive and non-executive incentive plans are being structured to meet several different planning objectives including the following:

  • Earning opportunities under executive officer incentive plans should be reasonable and capped, as cash incentive plans with unreasonably high payout opportunities may motivate executives to take excessive risks or manipulate earnings.
  • Incentive plans that relied historically on profitability or income goals are adding strategic and/or asset quality goals that focus on long-term viability.
  • Many banks with producer plans that pay out frequently are moving to annual payouts and considering holding back/deferring a portion of the incentive payout until it can be determined that a loan will not become problematic.
  • Mortgage lender compensation restrictions by the Federal Reserve and Dodd-Frank prohibit banks from paying mortgage lenders incentives that are based on fees.
  • Many banks are now including a long-term incentive component in executive pay-for-performance programs to help mitigate regulatory concerns that executives focus exclusively on short-term goals.
  • Today, the most common form of long-term incentive for publicly traded banks is restricted stock, which is viewed more favorably by the new regulations and guidelines. Restricted stock typically provides a stronger retention device than stock options and typically provides lower stock dilution rates.
  • Many private banks will use phantom stock and/or performance-based deferred compensation programs when real stock is not available.
  • Stock ownership guidelines and holding requirements (especially in public banks) are viewed favorably by regulators and shareholders.

Incentive compensation programs have experienced increased scrutiny in recent years. However, performance based compensation seems to be more useful than ever. Banks need to be more strategic and many are trying to drive a performance turnaround. To that end, identifying, quantifying, and driving the right performance plan can play a critical role and can differentiate your bank and your high performing employees from the competition.