Five Factors Directors Should Consider Before Granting Equity Awards

8-7-13-Pearl-Meyer.jpgThe three-year average total shareholder return of the KBW Regional Banking Index was greater than 13 percent as of June 30, 2013. Banking stocks are recovering, creating renewed interest in programs that reward executives appropriately for continued growth in share price and dividend yield.

Options provide the most direct reward for creating shareholder value. If the stock price goes up, executives and shareholders alike share in the upside. The counter argument is that options are far too subject to market whims and since an executive receives more “return” with options as the stock price increases, this could motivate the very behaviors that started the financial crisis. 

Restricted stock may seem like a safer alternative, but without some type of performance element, the awards may just serve as an incentive for executives to stay put, at least until their awards vest. 

In this environment, how do directors design equity awards that will provide a meaningful link back to shareholder value? 

There are five questions that directors can ask to gain clarity and create an effective equity grant strategy:

1. Who should receive an award?

There is often a consensus that senior management should receive equity as a normal part of the pay program. The subject of debate is typically who should receive awards below that level. Competitive practice, dilution and financial impact all play a role in determining how deep equity awards are granted within a bank. In our experience, the answer truly depends on the culture of the organization and what messages the bank wants to send regarding the behaviors that are most valued. If individual performance is important, defining and rewarding a pool of top performers can be highly effective. If revenue production is king, granting equity to top producers in areas such as commercial lending may aid in the retention of key rainmakers.

2. Is the goal of granting equity awards to reward performance or to retain executive talent?

In a recent survey conducted by Pearl Meyer & Partners, reward and retention tied at 89 percent as the top long-term incentive objectives for banks. Such multiple strategic objectives may call for granting both time- and performance-based awards. For example, a bank may decide to grant part of the award in time-vested restricted stock that is subject to holding requirements and provide the remainder as performance-based restricted stock.

3. Should performance-based awards strictly reward total shareholder return or operational performance that may result in a higher stock price?

In the same survey, nearly 70 percent of banks said they evaluate their long-term incentive programs on the basis of positive operational performance, versus 42.7 percent who focus on gains in total shareholder return. Members of management who believe that vagaries in the stock market are not under their control generally would prefer measures that correlate to increased shareholder value such as earnings per share, tangible book value, return on assets and return on equity as the key metrics for granting stock or vesting stock. 

4. Once an award is exercised or vested, what is the executive’s obligation?

One of the primary reasons for granting equity awards is to promote executive stock ownership, since tying a significant portion of an executive’s wealth to share price puts that executive on the same side as shareholders. The counterargument, however, is that long-term incentives are just that—incentives—and if performance is achieved, the executive should be able to reap the reward. Defining retention requirements and/or ownership requirements upfront can address these issues by establishing reasonable expectations around the executive’s obligation and what may be received as a reward.

5. How do we handle competing goals in our equity grant strategy?

Often, bank boards and management teams want to achieve multiple goals in their equity strategy. Being deliberate in the mix of equity types, the selection of eligible employees and the achievable retention/ownership guidelines will provide a balanced approach. 

New Thinking on How to Handle Key Employees

Companies are trying to rethink executive pay packages in an environment of increased media, shareholder and regulatory scrutiny. New rules on pay are encouraging pay structures to reduce risk. But the problem of getting and keeping great employees is as pressing as it’s ever been. Meyer-Chatfield Compensation Advisors President Flynt Gallagher talks about ways to reward performance while reducing risk.

Is pay-for-performance the best approach to attracting and retaining key executives?

Pay-for-performance is not new, but it seems to get reinvented when the economy doesn’t cooperate.  The idea seems perfect.  In reality, however, the process of connecting pay to performance is far more difficult than it appears.

For the most part, a large percentage of an executive pay package is tied to the company’s stock.  As a result, the market may not be rewarding the executives for doing a good job. The stock market is not a rational indicator of a management team’s success year to year. If a company’s stock price is the gauge by which an executive’s success is measured, does that mean that when the dotcoms had a high price they were well managed? Certain industries, even in bad times, are on the rise. Does that have anything to do with the quality of their management teams?   There’s a mixed signal to executives asking them to take a long term view, yet they are measured quarter to quarter by stock market performance. 

Is there a better way to handle executive compensation?

The key to our economic recovery is to remove the handcuffs and the government’s position on pay. We need to get back to the free enterprise system, the fabric America was built on, and provide the incentives for the talent needed. No company wants to over-compensate or under-compensate, but the decision regarding the amounts paid to executives certainly can’t be left to Washington.

Maybe it’s time for a little creative thinking. Companies need to be able to attract and retain the talent that will make a difference during this recovery and consider approaches outside the box.

Nonqualified deferred compensation is a device that can work in concert with a company’s strategy and unquestionably aligns the interest of the executive with shareholders. These plans are friendly to shareholders, as there is no dilution in ownership, nor does the company have any significant cost of providing a plan.  The monies deferred are held as general assets by the company, subject to the claims of the company’s creditors. Executives are not taxed on those dollars until they are withdrawn, because they are at risk if the company fails.

What are the benefits of a performance-based Supplemental Executive Retirement Plan?

Traditional SERPs have been criticized by the media, shareholders, shareholder advocacy groups, boards and even the academic community. Their main criticism is that these plans have no performance element to them. Despite the negative sentiment regarding SERPs, there likely will be increased use of these plans, however, with a new design twist focusing the contributions on company performance. This concept is worth consideration for those companies looking for cost effective ways to attract, retain and reward key employees who can make a difference. A properly designed performance-based SERP can help companies reward executives for achievements that drive the company in the right direction, without the volatility of the stock price.

What words of encouragement can we provide to the industry?

The only way many companies can recover is to have the right people in key management roles; therefore, attracting and retaining people is critical.  It’s time to think a little more creatively.

The media and Washington would have us all believe that the senior executives in major companies and their rush to line their own pockets are at the core of the nation’s economic woes.  Executive compensation packages have been vilified and considered to be nothing more than corporate greed that is limiting our economic growth.  But if we are going to get this economy turned around, aren’t these executives the same people with the potential to restore investor confidence and market growth?