FinXTech’s Need to Know: Elder Finances

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There’s a bit of a conundrum in the financial technology space. As more services move to the digital realm, the premise is that they become more accessible and relevant to a broader audience — specifically, millenials and Gen Z.

But self-servicing digital experiences don’t necessarily benefit an aging population.

A 2016 study from the U.S. Census Bureau reports almost 50 million adults 65 years and older are living in the U.S. That number is projected to surpass 100 million by 2060, which will outnumber the amount of children under 18 in the U.S.

There is no set age that represents an older adult’s inability to manage their finances — I know friends today who handle their parents’ finances while they are in their mid-forties, and also have a colleague whose father can still write checks at 90. Banks have an opportunity to facilitate the transition of financial management from adult to caregiver, and ensure that those customers stay with the bank.

Fintechs that specialize in the management and monitoring of elder finances can help banks ease the burden of that transition.

There are three main ways that fintechs can work with banks in this space: They can provide a digital banking platform tailored toward elder populations, they can monitor transactions for fraud and they can provide financial advisory services or planning.

Banks can work with fintechs to provide a digital banking interface that organizes elder finances for account holders. Managing insurance, retirement, medical, housing and emergency costs can feel next to impossible for caregivers who suddenly gain access to elder accounts. But, being able to access and manage those accounts from one platform could save time and prevent a potential headache.

Carefull is one such digital banking platform. Accounts can be set up by the elder themselves, with assistance or by a caregiver. From the platform dashboard, users can access past and future bills, income, deposits, assets and transactions made. An extra layer of transaction and fraud monitoring alerts users when suspicious activity is detected.

Multiple users can be added to the account on a view-only basis, and transactions can not be initiated or carried out by anyone except the elder within the Carefull platform. Users can even connect with financial advisors and planners within the bank.

Elder fraud can be extremely difficult to spot, and increasingly common. A 2019 report from the Consumer Financial Protection Bureau looked at Suspicious Activity Reports (SARs) that dealt with elder financial exploitation from 2013 to 2017. The study found that filings quadrupled within those four years, and that those reported accounted for only a fraction of incidents.

When elder fraud occurs — whether it be malicious (from a bad actor), a crime of opportunity (from a caregiver) or a self-induced mistake (falling for a phishing scam) — the losses are apparent. The average lost in each SAR totaled $34,200. Losses were greater when the elder knew the perpetrator versus a stranger: $50,000 compared to $17,000.

EverSafe works as a second set of eyes on bank, investment, retirement and credit card accounts. Its analytics technology looks for irregularities within transactions, transfers or withdrawals made from each account, and sends alerts to a trusted caregiver, whether it be a spouse, child or hired help. EverSafe, with a partner bank, can also help guide families through remediation processes when fraud or theft occurs, and in some cases will reimburse lawyer fees.

Banks can take a proactive approach with aging populations with fintechs that offer advisory services — assisting with in-person advisors or through artificial intelligence. Genivity’s HALO platform operates as a software-as-a-service solution that helps bank customers plan for the biggest risks to their longevity, health and finances. Each customer receives a personalized report that includes how many years they are expected to live with assistance and its cost, including out-of-pocket expenses.

Full reports are given to financial advisors, so that clients are incentivized to speak with them about their future financials. HALO can be white-labeled and embedded directly into a bank’s digital platform.

Banks will have to strengthen their reactive and proactive strategies when it comes to protecting and catering to aging populations — and partnering with a fintech may be the best way forward for many. Doing so may help banks accumulate life-long customers across generations.

Carefull, EverSafe and Genivity are all vetted companies for FinXTech Connect, a curated directory of technology companies who strategically partner with financial institutions of all sizes. For more information about how to gain access to the directory, please email [email protected].

Improving Shareholder Liquidity, Employee Performance through ESOPs

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ESOP-6-18-19.pngMost banks face challenges to find, incentivize and retain their best employees in an increasing competitive market for talent. Often, smaller banks and banks structured as Subchapter S corporations have the added challenge of providing liquidity for their shareholders and founders. An employee stock ownership plan can be an excellent tool for addressing those issues.

An ESOP creates a buyer for the bank’s stock, generating liquidity for shareholders of private or thinly traded banks and providing market support for publicly traded ones. An ESOP’s buying activity can reduce shares outstanding and increase a bank’s earnings per share. It can also increase employee benefits and gives them a sense of ownership that can improve recruitment, retention and performance.

ESOPs are tax-qualified defined contribution retirement plans for employees that primarily invest in employer securities. ESOPs offer accounts to employees, similar to 401(k) retirement plans. But unlike a 401(k), employees do not contribute anything to the plan; instead, the bank makes the contribution on their behalf.

ESOPs are an excellent employee benefit and a recruitment, retention and performance tool. ESOPs do not pay taxes on an annual basis, so taxes are deferred while the stock remains in a plan. When the employee retires or takes a distribution from the plan, the value of the distribution is taxed as ordinary income. Employees also have the ability to roll over the distribution to an individual retirement account.

Employees at companies that offer an ESOP have, on average, 2.6 times more in retirement assets than employees working at companies that do not have an ESOP, according to the National Center for Employee Ownership. Additionally, companies with broad-based stock option plans experienced an increase in productivity of 20 percent to 33 percent above comparable firms after plans were implemented. Medium-sized companies saw gains at the higher end of the scale. Employee ownership is also associated with higher rates of employee retention. According to a survey by the Rutgers University’s NJ/NY Center for Employee Ownership, workers at employee-owned companies are less likely to look for other jobs and more likely to take action when co-workers are not working well.

There are a couple of different ways that banks can establish ESOPs. The simplest and most efficient is called a non-leveraged ESOP, where the bank or holding company makes a tax-deductible cash contribution. The contribution can be in stock or cash and is recorded as compensation expense. If the bank contributes cash, those funds can be used to purchase stock directly from shareholders and create liquidity and demand in the stock. However, it can take years for a non-leveraged ESOP to accumulate a significant enough position to make a meaningful difference to a bank.

The other method, called a leveraged ESOP, uses a bank’s holding company to lend money directly to the ownership plan. The holding company is required because banks are not permitted to lend directly to the ESOP or guarantee a loan made to the ESOP. The holding company can use cash on its balance sheet, borrow it from a third-party lender or guarantee a third-party loan made directly to the ESOP. The ESOP uses the funds to purchase a large block of non-issued shares from the holding company or directly from shareholders. Although leveraged ESOPs have higher costs and complexity, they can make an immediate, meaningful difference in liquidity and employee benefits. This approach also has the benefit of increasing earnings per share upfront, since the shares underlying the ESOP loan to make the purchase are not considered outstanding. However, the repurchased shares negatively impact tangible common equity and tangible book value.

An ESOP can help the right bank accomplish many of its goals and objectives. Banks should carefully review their goals and objectives with qualified professionals that know and understand both the ESOP and commercial bank industries.

What’s Changed in Executive Compensation Since the Crisis

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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.

Perquisites
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.

Summary
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.

The Resurging Interest in Bank Supplemental Executive Retirement Plans

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SERP-4-6-17.pngThe roller coaster ride in banking over the last eight to 10 years took another unexpected turn in November with the election results. The financial sector gained new life, bank stocks soared and community banks began to see the prospect of regulatory relief becoming a reality. Interest in de novo banks has been picking up, and the likelihood of interest rate increases and decent loan demand appear to bode well for banks.

With that as a backdrop, the need to retain key members of a bank’s management team has re-emerged. Loan demand is good, profits are rising, optimism regarding regulatory relief is growing and the need to stabilize the management team of the bank is on the front burner as the talent grab has begun to heat up. Comprehensive compensation plans that serve to retain, reward and appropriately retire management teams are back in the spotlight.

During the financial crisis, many banks maintained salaries, as well as short and long-term incentive plans. Qualified benefit plans were continued, though often temporarily curtailed. But one key element of retention and reward, non-qualified plans, were either terminated, frozen or not introduced at all. Supplemental Executive Retirement Plans, or SERPs, are some of the most common non-qualified plans. Since the financial crisis, SERPs have lately seen a resurgence due to their multi-faceted benefit to both the bank and executive.

Objectives of a SERP

  1. Retirement: Since inception, SERPs were designed to allow the company to provide supplemental benefits to executives whose contributions to traditional qualified plans such as 401ks and profit sharing plans were limited by the Internal Revenue Service or ERISA (The Employment Retirement Income Security Act). For example, the general employee base may be able to retire with 75 to 80 percent of final salary based on income from Social Security and qualified plans while the executive team was retiring at 35 to 45 percent from the same sources. In essence, those executives were discriminated against due to the ERISA and IRS caps. SERPs bridged the gap and allowed for the bank to provide commensurate benefits to key executives.
  2. Retention: SERPs are non-qualified plans. They do not have the restrictions of qualified plans regarding vesting terms. As a result, the bank can structure the terms in the SERP however they desire from a vesting perspective. For example, assume an executive is to receive $60,000 per year for 15 years in a SERP. If in year five, the executive gets an offer from another bank, depending on the plan vesting, the executive may be walking away from all, or a large portion, of their SERP benefit. That’s $900,000 in post-retirement income at risk. This deterrent becomes a “golden handcuff.”
  3. Reward: Banks can use SERPs whose value are determined based on performance measures. There may be a return on equity or return on assets threshold needed to get a minimum percentage of final salary from the SERP. That percentage would grow based on performance measures established in the plan.
  4. Recruiting: SERPs provide the bank a plan that attracts talent. If the target executive is working at an institution that does not provide SERPs, the plan becomes an added attraction to joining your organization.

Other Items of Consideration

Unfunded, unsecured promise to pay: It is important to note that non-qualified plans such as SERPs are balance sheet obligations of the company and must be accrued for under generally accepted accounting principles (GAAP). The plan is an unfunded promise to pay by the bank. As a result, if the bank were to fail, the executive would lose his or her benefit. The SERP benefit is often matched up with bank-owned life insurance (BOLI) to provide income to offset the SERP accrual. This is not a formal funding of the plan, but a cost offset.

Top-hat guidelines: Executives participating in a non-qualified plan must qualify under top-hat guidelines as provided under the Department of Labor. These guidelines are murky, and consider position in the organization, compensation, negotiating ability (with the bank) and number of participants as a percentage of full-time equivalents. If there is any concern about who can participate, it is best to have legal counsel review prior to implementation.

In summary, SERPs are back in favor. The practical need for equitable retirement benefits, as well as the ability to retain, reward and recruit all have been catalysts in the resurgence of SERPs in the banking marketplace.

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

What Are the Best Ways to Fund Your Retirement Plans for Executives and Directors?

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retirement-plan-4-20-16.pngNonqualified deferred compensation (NQDC) plans continue to be important tools to help banks attract, reward and retain top talent in key leadership positions. In order to retain their critical tax deferral benefits, such plans must remain unfunded. For tax purposes, a plan is “funded” when assets have been unconditionally and irrevocably transferred for the sole benefit of plan participants. Formal funding of qualified plans, such as a 401(k), does not subject the participants to immediate taxation—participants can defer taxes until they actually receive such income. However, qualified plans have limitations on the level of benefits that can be provided and these limits can lead to substantial shortfalls in expected retirement income for executives and other highly compensated persons. NQDC plans came about specifically to help offset those shortfalls.

The restrictions on funding NQDC plans leads plan sponsors to search for solutions to finance or economically offset the costs of providing enhanced benefits to NQDC plan participants. When you hear someone refer to “funding a NQDC plan,” this is what they mean. Economic, or informal, funding means that the bank acquires and owns the particular asset of that funding method and that at all times such assets are subject to the claims of the bank’s creditors. Our objective for this article is to review and compare the financial statement impact of various methods for economically funding such plans. In our examples we use a Supplemental Executive Retirement Plan (SERP) and the following funding methods: 1) unfunded; 2) bank-owned annuity contract; 3) bank-owned life insurance (BOLI); 4) a 30-year, A-rated corporate bond; and 5) a 30-year, bank-qualified municipal bond. The same investment allocation and same cost of money were used in scenarios two through five.

  1. Unfunded
    A benefit plan is implemented and no specific assets are earmarked to generate income to offset the expenses. The bank accrues an accounting reserve for the benefit liability as required under GAAP and makes payments out of general cash flows. This method is simple and has often been used when the bank does not have additional BOLI capacity.
  2. Bank-Owned Annuity Contract
    The bank purchases a fixed annuity contract (variable annuities are not a permissible purchase for banks) on the lives of the plan participants. While the primary advantage of purchasing an annuity is that the cash inflows from annuity payments can be set to match the cash outflows for benefit payments, because corporate-owned annuities do not enjoy the tax deferral benefits of individually owned annuities, there is a mismatch of income taxation (annuity) with income tax deductions (benefit payments). Fixed annuity contracts with a guaranteed lifetime withdrawal benefit provide a specified annual payment amount commencing when the executive reaches a certain age (usually tied to retirement). Payments are made for the life of the annuitant. Fixed annuity contracts generally do not respond to movements in interest rates.
  3. Bank-Owned Life Insurance (BOLI)
    The bank purchases institutionally priced life insurance policies on eligible insureds to generate tax-effective, non-interest income to offset and recover the cost of the benefit plan. When properly structured and held to maturity, earnings on BOLI policies remain tax-free, eliminating the tax mismatch issue. The tax-free nature of BOLI earnings often allows the bank to exceed the yields on taxable investments on a tax-equivalent basis. Top BOLI carriers structure their products so that they do respond to market rate movements, albeit on a lagging basis.
  4. 30-Year, A-Rated Corporate Bond
    A 30-year, A-rated corporate bond is a simple and transparent investment vehicle. Because investment earnings are taxable as earned, and benefit payments are not deductible until paid, the tax mismatch is the primary disadvantage. Corporate bonds do respond to market rate movements, leading to potential volatility in market values.
  5. 30-Year, Bank-Qualified Municipal Bond
    A 30-year, bank-qualified municipal bond is similar to a 30-year corporate bond except the earnings are tax free.

In summary, key to the funding analysis is evaluating the best investment for the bank that will mitigate the impact of the plan expenses and liabilities on the bank’s financial statements with bank-eligible investments. The following table summarizes the projected net financial statement impact of the five methods discussed above in both today’s interest rate environment as well as the projected impact in a rising rate environment. As you can see, BOLI and a 30-year bank-qualified municipal bond offer some of the better ways of funding the plan over time.

Funding Your NonQualifed Deferred Compensation Plan

  Projected Life of Plan Net Income(Expense)*
Method of Funding Today’s Rate Environment Rising Rate Environment
Unfunded $(772,439) $(772,439)
Bank-Owned Annuity Contract $(164,229) $(439,597)
Bank-Owned Life Insurance (BOLI) $190,369 $1,598,371
30-Year A Rated Corporate Bond $(114,989) $(235,872)
30-Year Bank-Qualified Municipal Bond $221,007 $701,441

*Based on $500,000 single premium investment. Current rates are as of March 2016. For more detailed information as well as the relevant assumptions used, please contact David Shoemaker at [email protected] or 901-754-4924.

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

Are Your Retirement Vesting Provisions Motivating the Wrong Behaviors?

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incentive-1-4-16.pngAs more executives near retirement age, many banks are realizing their equity vesting provisions may be motivating unintended behaviors. Do your bank’s retirement provisions encourage executives to:

  1. Provide advance notice of retirement to facilitate planned succession?
  2. Assist in their transition?
  3. Remain engaged and motivated through the last day on the job?
  4. Remain interested in the bank’s success following retirement?

Unfortunately, many retirement provisions don’t consider these important objectives and in some cases motivate the opposite behaviors.

Current and Emerging Retirement Provisions

Forfeit
Forfeiting all unvested equity may be used as a means to retain executives, but this practice can unintentionally encourage executives to wait around for equity to vest when the executive is no longer fully engaged.

Fully Accelerate
Accelerating unvested equity upon retirement allows executives to announce and retire whenever they want without losing any equity. However, if an executive communicates an intention to retire two months before an equity award, does the company make the award? Not doing so could impede the executive’s motivation to provide advance notice of pending retirement. However, full acceleration can limit the retention value of awards once the executive reaches (early) retirement eligibility.

Prorate
Proration provides executives with a portion of unvested equity based on the amount of time the executive has worked during the vesting period, regardless of when the grant was made. The bank may be uncomfortable with executives receiving value from recent grants, while executives may feel that they are forfeiting earned compensation. Below are three potential solutions to this concern which combine proration with acceleration:

  1. Holding Period. Participant must have received the grant at least 6-12 months prior to retirement in order for vesting to accelerate or performance awards to vest.
  2. Prorated 12 Month Period. The amount of award that accelerates or vests is based on the portion of time worked during the first year after grant. If a participant works for six months following a grant, he/she would receive value of half the award. This alternative is more generous and does not create as much of a cliff timeline.
  3. Most Recent Grant Pro Rata. Equity accelerates in full except for the most recent grant (made in the last 12 months) which would vest pro rata based on the full vesting period of the award (e.g., if stock options vest ratably over 4 years, a participant who works for six months during year one would receive one-eighth of the award).

Continue Vesting
Continued vesting is an emerging practice with benefits for the executive and the bank. Continued vesting allows the executive to retire without forfeiting all or a portion of outstanding awards. Instead, the awards continue to vest on the original schedule. This also encourages the executive to leave the bank in sound condition and facilitate transition. Another benefit for the bank is that continued vesting helps reinforce non-compete or non-solicit agreements because the bank can cease vesting if the executive violates the restrictive covenant.

Committee Discretion
Some committees want the discretion to determine retirement treatment on a case by case base. This treatment acknowledges that each executive is different and each retirement situation is unique. However, this approach puts a significant pressure on the committee and may be perceived unfair by executives if the discretion is not applied consistently.

Other Considerations

Retirement Definition
Banks should also review the retirement definition to ensure it remains appropriate. If a bank’s retirement age is 65, what is the treatment if an executive is hired at age 64? Some banks define an age plus service definition such as age 65 and 5 years’ service or an age and service definition to recognize early retirement (e.g. 55 age plus 10 years’ service or age plus service equals 75). For these definitions, banks may want to consider including a “retire from the industry” requirement in their retirement definition.

Performance Awards
Should performance award payout be based on target or actual performance? Awards paid based on actual performance at the end of the performance period could encourage the retiring executive to leave the bank in sound condition.

Vesting Schedule
Finally, the vesting schedule may also impact which type of retirement provision a bank chooses. For example, if time-vested restricted stock vests ratably over three years (i.e. 1/3 per year), a forfeiture provision would not be as detrimental to the executive as if the award was cliff vested.

Choosing the right retirement treatment is a more strategic decision than ever before. Banks should review their long-term incentive plans to ensure they are meeting desired objectives.

Performance-Driven Retirement Plans: Are They Right for Your Bank?

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1-5-15-Equias.pngBank boards do not like to lose executive talent to competing banking organizations. Developing a compensation plan that is aligned with shareholder interests and retains key executives continues to be an important objective for compensation committees. Compensation committees need to evaluate a variety of compensation strategies to determine which will be the most effective at retaining and recruiting key high performing lenders and executives. While offering competitive salary and performance-based annual bonus amounts are a given, providing additional long-term incentives and/or retirement benefits can be the missing component. Equity plans provide an element of longer-term compensation, but are not available in many privately-held banks and, even where offered, can be complemented by other types of long-term incentive plans.

According to the American Bankers Association 2013 Compensation and Benefits Survey, 64 percent of respondents offered some kind of nonqualified deferred compensation plan for top management (CEO, C-level, executive vice president). (See our article, “Is Your Compensation Plan Generous Enough?”) Choosing the right retirement plan must incorporate the compensation committee’s overall compensation philosophy and bank objectives.

This article will focus on performance-driven retirement plans, a type of defined contribution nonqualified plan. Long-term incentive plans that are performance driven are generally well-received by shareholders. When such plans are properly designed, if the bank’s shareholders do well, so will the executives.

As an example, let’s assume the bank desires to implement a performance-driven retirement plan for a key lender who is 35 years old. Let’s also assume that if the lender meets both department and individual target goals along with the bank-wide net income goal, the lender will receive an annual grant of 10 percent of salary. The bank will cap the grant at 20 percent of salary if maximum performance goals are attained. For this individual, assume the annual contribution is based on a combination of loan growth, deposit growth and bank-wide net income. The goals and the weighting of each goal will vary by officer.

Assuming normal retirement age of 65, and 10 percent of salary contributions each year, the executive is projected to be credited with almost $400,000 in bank contributions. With interest added to the account, the retirement benefit is expected to be almost $80,000 per year for 15 years, a total benefit of $1.2 million. The payments are contingent on the executive not taking a job where he or she competes with the bank after retirement.

This type of arrangement is documented in a legal agreement between the bank and the executive. The agreement must comply with IRC Section 409A and should address various agreement terms and conditions including:

  • Early voluntary termination
  • Disability
  • Change in control
  • Pre-retirement death 
  • Death during payout
  • Non-compete and non-solicitation of customers and employees
  • Holdbacks
  • Qualifiers such as satisfactory performance evaluations and credit quality
  • Form (number of years) and timing (age or date) of benefit distributions

It is critical that bank-wide goals along with department and individual goals be linked to the bank’s budget and overall strategic plan. The goal setting process is typically the most challenging step in designing the plan. Some banks use moving averages (such as the bank’s three-year average net income) and other longer-term measures to determine executive performance and bank contributions.

Rewarding executives with a meaningful compensation package tied to long-term shareholder return is a balancing act. While there is not a one-size-fits-all approach for designing and implementing this type of plan, the facts and circumstances of each bank will dictate the best design after taking into account the bank’s culture and compensation philosophy.

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

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..

How to Retain Key Employees: The Benefits of a SERP

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8-16-13-Meyer-Chatfield.pngAre you better off with or without them? That is a question advice columnist Ann Landers asked her readers. The answer is even more relevant when discussing key employees of community banks. As we emerge from the Great Recession, employee retention remains a primary focus. In a recent Bank Director survey, 40 percent of bank boards identified retaining key employees as a significant challenge. In fact, 44 percent of banks nationwide lost key executives or critical employees in the past three years.

What can banks do to retain key employees? Prior to the financial crisis, conventional wisdom accepted equity grants as the best method to retain executives and tie compensation to performance. Then came the economic downturn and those same equity grants looked like a reason for the lax credit policies whose aftermath continues to bedevil banks. Remember, many executives that received those rather large equity grants were approaching retirement age as the first wave of baby boomers. Their opportunity to benefit from equity grants had to be realized in a relatively short period of time, creating pressure for ever increasing earnings and price appreciation. History shows it did not turn out as expected.

Now, let’s reconsider a popular executive compensation benefit that fell out of favor in the wake of media and shareholder outrage. Prior to the economic downturn, many banking executives benefited from a supplemental retirement plan in addition to the company pension plan or 401(k) plan. These Supplemental Executive Retirement Plans (SERPs) were intended to provide benefits to replace the limitations imposed by Internal Revenue Service regulations. As a retention tool, SERPs are extremely effective. Typically SERPs require the executive to stay until retirement age to receive the benefit. For example, a SERP may provide an annual benefit for the executive of 40 percent to 60 percent of salary for up to fifteen years after retirement. In the event the executive leaves to work for a competitor, the SERP is forfeited. The primary objective of all compensation plans—to influence the decision making of the employee—is achieved with a SERP.

Is the expense worth it? Yes. For illustration purposes, let’s assume a bank has a SERP with a benefit of $100,000 per year for 15 years. The total cost to the bank is $1.5 million. Although spread over many years, it is still perceived as expensive. The cost on an after-tax basis is about $900,000 assuming a top tax rate of 40 percent. In an environment of detailed compensation disclosure, this seems excessive. But is it really?

Let’s look at the terms SERPs impose. First, executives must be employed with the bank until retirement. The bank is the guarantor of the benefit, not a third party as in the case of a 401(k) plan or a pension plan. For rank and file employees, if the bank fails, their retirement plan is guaranteed by a third party or the Pension Benefit Guaranty Association. With a SERP, the bank is the guarantor. If the bank fails, there is no one to make the payment and the executive loses the promised retirement benefit. Similarly, if the bank fails after the executive’s retirement, there is no one to make the payments.

One of the responsibilities of any manager is to develop talent to eventually succeed him or her. In this scenario, a 50-year old executive granted a SERP must focus on protecting shareholder value until retirement (age 65) and ensure the successor is capable—and motivated—to do the same. Thirty years is not a bad deal in exchange for a cost of $900,000.

When properly designed, the benefit to the bank and shareholders is greatly in excess of the cost of a SERP. Heidrick & Struggles, an executive search firm, says an incoming executive takes up to 18 months to achieve the level of productivity he or she provided prior to accepting a new position. This cost combined with what is known as the lost opportunity cost of not having a fully effective executive in a critical position makes the cost of a SERP appear minimal.

Top executives drive shareholder performance. If retaining these key employees is important to your bank’s future, then now is the time to make sure your bank doesn’t become one of the 44 percent who lost a key employee.

Stock Bonus Plans for Community Banks

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nest-egg.jpgCompanies are cutting employee benefits to conserve cash. There is another approach. Banks can sponsor retirement plans which provide deductible employee benefits in the form of stock, not cash, and reward the folks who build value over time.

How Does a Stock Bonus Plan Work?

It is a retirement program that works much like a profit-sharing plan, permitting the sponsoring company to make tax-deductible contributions in cash or stock to participant accounts. The limit is 25 percent of eligible compensation aggregated for all qualified plans.  

So, if a community bank with a payroll of $2 million makes a $50,000 match on the 401(k) plan, the deduction limit for an additional stock bonus contribution would be $50,000 less than 25 percent of $2 million, or $450,000. While most banks would typically contribute a much smaller percentage of compensation, the key is to understand the limits. 

Who Benefits from a Stock Bonus Plan?

In the above example, the bank had 49 employees with seven employees making more than $100,000 annually; these seven received 47 percent of the total compensation.  Since the allocations to participant accounts were made in proportion to pay, the 10 percent of payroll ($200,000) contributed meant that the key group received $94,000 in stock. The non-discriminatory plan meant that the non-highly compensated group received the balance of the shares in the plan.

Curiously, these plans sometimes better suit smaller banks specifically because of the need to reward key players and the ability of some stock bonus designs to skew benefits to them. Large plans with hundreds of participants can spread ownership more broadly.

The bank holding company sponsoring the plan received a tax deduction for the $200,000 non-cash expense and a resulting cash flow improvement (analogous to the tax effect of depreciation). This would not be possible if you contributed cash instead of stock to a retirement plan. The end result is more cash saved on the balance sheet. The table below illustrates this in a hypothetical example.

Three retirement plan options were considered: A) cash contribution; B) no contribution; C) stock contribution.  

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What Are Five Must Dos for Stock Bonus Plans? 

  1. Use an independent stock valuation for the share value, if the corporation is closely held or thinly traded.
  2. Coordinate the capitalization and shareholder (dilution) effects with a comprehensive benefit strategy for both the highly and non-highly compensated employees.
  3. Base the cost/benefit analysis on the ongoing plan operating costs, cash savings and the long-term obligation to repurchase shares from former plan participants when they retire. 
  4. Maximize the benefit of employee ownership by communicating the plan clearly to the participants.
  5. Consider using the more versatile Employee Stock Ownership Plan (a sub-class of stock bonus plans), if the intent is for the plan to purchase shares rather than operate as a simple contributory plan. A stock bonus plan cannot purchase stock from shareholders, while an ESOP can; the ESOP can even borrow money to buy the shares; both types of plans hold the majority of their assets in company stock.

What Are Three Things Not to Do?

  1. Implement a stock plan where the organization’s operating profits (<$500K) or numbers of employees (<30) do not warrant the cost.
  2. Convert the 401(k) plan of a closely-held sponsor to any of the forms of stock bonus arrangements and use employee money to purchase shares or otherwise have stock in employee-directed accounts.
  3. Consider stock compensation in troubled banks with problematic “going concern” valuations or questions about viability. 

Conclusion

Successful banks may be tempted to curtail employee benefits in a difficult economic environment, but may in fact be better served in terms of employee motivation and operating results by a restructuring of the benefit program. There are many other rules and variations on the stock bonus theme; a decision should be narrowed to the main pros and cons through a review with skilled designers.