Compensation for Privately Owned Banks: What to Know

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incentive-plan-11-9-15.pngPrivately held banks, including Subchapter S banks as well as mutuals, are no different than publicly traded banks in their efforts to provide meaningful compensation plans for their key officers. Privately held banks must compete with public banks when attracting and retaining key officers and producers.

Publicly held banks typically offer restricted stock or incentive stock options to key employees. This is much more difficult for privately held banks due to a lack of available shares or illiquidity of the stock. Therefore, privately owned banks competing for talent often require more creativity.

While some privately held banks offer stock options, restricted stock or restricted stock units (RSUs), these types of plans are uncommon. Rather, privately held banks that want to provide rights of ownership to executives often use synthetic equity such as Phantom Stock Plans (PSPs) and Stock Appreciation Rights (SAR) plans. While these plans have an earnings impact to the bank, they do not have a per-share dilution as no actual shares are issued.

Competition for top talent is strong. Assuming the bank offers a competitive salary and an annual incentive plan, the challenge is the ability to offer a long-term incentive/retirement plan. The following types of plans are often used to attract and retain key executives and include:

  • Supplemental executive retirement plans (SERP) can be designed to address an executive’s shortfall that would result if the executive only had social security and the bank’s qualified plan to provide retirement income. Generally, under the terms of a SERP, an institution will promise to pay a future retirement benefit to an executive separate from any company-sponsored qualified retirement plan. The benefit is typically expressed as a fixed annual dollar amount or as a percentage of final compensation.
  • Deferred compensation plans (DCP) allow the bank to make contributions to the executive’s account using a fixed dollar amount, fixed percentage of the executive’s compensation, or a variable amount using a performance-based methodology. The DCP can also allow the executive to defer his or her current compensation.
  • Split dollar plans allow the bank and the insured executive to share the benefits of a specific BOLI (Bank-Owned Life Insurance) policy or policies upon the death of the insured. The agreement may state that the benefit terminates at separation from service or it may allow the executive to retain the life insurance benefit after retirement if certain vesting requirements are met.
  • Survivor-income plans/death benefit-only plans specify that the bank will pay a benefit to the executive’s survivors (beneficiaries) upon his or her death. The benefit may be paid in a lump sum or in annual payments over a specified time period. Typically, the bank will purchase BOLI to provide death proceeds to the bank as a hedge against the obligation the bank has to the beneficiaries. The benefits are paid directly from the general assets of the bank.

Picking the right plan design is only part of the process. Striking the proper balance between making the plan attractive to executives but not excessively expensive to the company are also significant factors when designing the benefit plan. Nonqualified plans can be customized to each executive, avoiding a cookie cutter approach by allowing flexibility in the amount of the benefit, vesting schedule, non-compete provisions, timing of payments and duration of payments. For example, assume you provide a substantial retirement benefit to a 40-year-old executive, but provide no vesting until age 65. The executive will likely not see it as a valuable benefit since most 40-year-olds think they will retire long before age 65. Likewise, if the executive is fully vested at age 55, the executive may not be motivated to stay past that age.

The plan must also provide a fair benefit upon death, disability and change in control. The payment terms can be customized to fit the needs of the executive while remaining in compliance with IRC Section 409A of the tax code. A properly designed nonqualified plan can enhance the bank’s bottom line by attracting and retaining top talent, but doing so in a way that is cost-efficient to the bank.

With over 30 years of history, BOLI has proven to be an effective tool to help offset and recover benefit expenses. While many public banks purchase BOLI to recover the cost of general benefit liabilities only, many privately held banks purchase BOLI for the same reason, but also include recovering the cost of nonqualified plans. BOLI is a tax-advantaged asset whereby every $1 of premium equates to $1 of cash surrender value (CSV) on the bank’s balance sheet. The CSV is expected to grow every month and earnings are booked as non-interest income on a tax preferred basis. From a cash flow perspective, BOLI is a long-term accrual asset that will return cash flow to the bank upon the death of the respective insured(s). BOLI is an investment asset that currently generates a return in the range of 2.50 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 4.03 percent to 5.65 percent (assuming a 38 percent tax bracket).

Summary
Privately held banks must compete with all types of organizations for talent. Their future is dependent on their level of success in attracting and retaining key executives. The use of nonqualified plans, when properly chosen and correctly designed, can make a major impact on enhancing long-term shareholder value.

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

Taking the Fear out of Phantom Stock

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The use of equity compensation has increased in the banking industry in recent years, coinciding with enhanced compensation guidelines from the Securities and Exchange Commission (SEC), bank regulators, and the Dodd-Frank Act. These parties recommend that some executive compensation be deferred and tied to long-term performance. Equity programs typically accomplish both of these goals. A recent study of 177 public banks from Blanchard Consulting Group’s internal database found that the use of equity grants as a percentage of total compensation increased two to three times from 2009 to 2013, depending on the asset size of the bank.

Asset Size 2009 Proportion of Equity to Total Compensation 2013 Proportion of Equity to Total Compensation
Over $1B 15% 26%
$500M to $1B 4% 12%
Under $500M 4% 7%

Most publicly traded banks will use compensation plans tied to the organization’s stock to distribute long-term incentives in the form of stock options or restricted stock. Some private or thinly traded banks will use these types of “real” stock programs; however, many of these banks have limited availability of actual stock. As an alternative, private banks may use synthetic equity, such as phantom stock or stock appreciation rights, which are settled in cash.

Phantom stock programs are modeled to look and feel like restricted stock, where the participant receives the full value of the share plus any appreciation over time. The value of phantom stock is typically linked to the company’s stock price or book value per share. In addition, dividends could be factored into the phantom stock value during the vesting period, typically 3-5 years. Ultimately, the phantom stock awards will be settled in cash.

Advantages to Synthetic Equity
Banks concerned with equity dilution often prefer phantom stock, which provides a value comparable to that of restricted stock, but does not result in actual equity dilution. The value of the phantom stock is paid out in cash upon vesting, so the officer still receives value commensurate with having a real share of stock. Because phantom stock is settled in cash, it does not receive equity-based accounting treatment (value fixed at grant date). Instead, the expense is adjusted over time to reflect changes in the bank’s stock price or book value. The advantage of using phantom stock is the absence of any share dilution.

Stock Appreciation Rights (SARs) are another form of synthetic equity that are settled in cash. Cash SARs work similarly to stock options, as SARs give the participant the right to any appreciation in stock price or book value between the grant date and settlement. The appreciation value is paid in cash and taxed as ordinary income. Similar to phantom stock, cash SARs do not receive equity-based accounting treatment. The SARs are re-valued periodically, and the expense is adjusted to reflect the changes in value throughout the vesting period. This could lead to expensive accruals if the underlying stock price increases dramatically. Similar to phantom stock, there is no share dilution.

Other Considerations
Before implementing any type of equity or long-term incentive plan, a bank should consider a number of factors, such as the following:

  1. Performance-based awards: In today’s environment, equity awards are typically based on the achievement of bank-wide, department and/or individual goals.
  2. Service vesting: We typically see three to five-year vesting schedules within the banking industry. The vesting schedule may vary by grant or employee based on the bank’s retention goals.
  3. Dividends: The board should determine when and if the plan participant will receive value for dividends. This provision can be customized by the bank for each eligible employee.
  4. Termination of employment: If a participant voluntarily terminates employment during the plan term, the employee typically forfeits any unvested awards.
  5. Death or disability: Most banks will accelerate vesting and allow the participant or beneficiary to exercise shares in the event of a disability or executive’s death. All early disbursements will need to comply with Internal Revenue Service (IRS) restrictions (section 409A).
  6. Change-in-control: Shares will typically vest immediately and be paid upon the acquisition or merger of the bank if an employee is terminated as a result, also known as a “double trigger”.
  7. Clawback provision: This allows the bank to recoup incentive compensation payments made to plan participants in error from any unvested phantom stock or SAR grant.

In order to retain and attract talent, private banks need to ensure that they have the compensation tools available to compete with public banks that use real stock compensation. By using phantom stock or SARs settled in cash, private banks can help ensure that they are competitive with the market.