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You Get What You Pay For

By Arthur Warren, Esq.

A wholesale dismantling of widely-used reward tools is not the right approach in the new economy.

In today’s volatile economy, less bad is the new good. Thousands of community bank CEOs are hardworking, and ethical. They are not accountable for the past lack of oversight on financial issues by regulators, bank commissioners and elected officials. Yet they face the dilemma of how to respond to the hot button media topic of the day: executive compensation.
The federal  economic stimulus package is creating unprecedented action by bank compensation committees to cut executive compensation and benefits, often as a response to perceived public pressures rather than the realities of recession-based economics.

Retaining Key Personnel
But these public pressures present business opportunities. When mega-bank customers leave, or are cast off regardless of their good credits and “A” list status, where will they go with their business? Community banks have an opportunity to direct and prepare employees to capitalize on this unique situation.
The problem is how community bank boards motivate and retain the key personnel with the talent to successfully execute the business plan. Reducing payroll costs in a recession is prudent only if the CEO can retain the key contributors necessary to ensure the bank’s long term success. Even in this economy, headhunters are calling for bank executives with a customer base, such as commercial lenders and branch retail managers.
Unfortunately, the fear of future regulatory scrutiny is prompting some compensation committees to eliminate bonuses, curtail merit increases and cancel long-term deferred compensation. Some of this action is not justified and may, in part, contribute to a bank’s future underperformance.
Placing severe limits on executive short and long-term performance bonuses is exactly the wrong action to take at a time when enhanced focus and improved performance is demanded.
Here are some common strategies many community banks are implementing to address this recession, possible deflation and industry consolidation trends.

Compensation Philosophy
This year, informed boards are making extra effort to link pay and performance. They’re also revisiting their executive compensation philosophies to ensure they are emphasizing the right forms of compensation and have identified sufficient rigor in their performance targets. For publicly traded banks, stockholder “Say on Pay” is a reality and any executive’s attempts to game the compensation system will be attacked.
I am actively encouraging non-stock banks to form board compensation committees comprised of outside directors to develop formal total compensation objectives for their senior management teams.
Remember to value all bank-provided executive compensation elements: base, incentives, benefits and perks. While it is clearly critical for all pay elements to be balanced and well designed, a wholesale dismantling of widely used reward tools is not the right approach in the new economy.

Rationalizing Benefits Not Linked To Performance
New proxy disclosure rules highlight nonperformance-related programs like severance and perquisites. The key issue is deciding which programs to keep without leaving the board open to criticism for ‘paying for failure.’ Be cognizant that board claw-back policies, such as the retraction of compensation or stock as the result of a special-arising circumstance, will impact stock banks more than non-stock banks. Avoid tax gross-ups (additional compensation to cover an executive’s personal tax liabilities) in any form as they are a target for stockholders and regulators. Eliminate executive perks unrelated to direct business benefits to the bank.
While some programs have outlived their usefulness, others continue to serve valid recruiting and retention objectives: supplemental executive retirement plans (SERPs) are key to recruiting executives in the banking industry where they are virtually universal. Additionally, SERPs often serve as an equity substitute for non-stock banks.

TARP
TARP may be helpful for banks that are capital-strapped, but be careful to read the small print and to consider the reputation risk due to public distrust. New mandated restrictions for TARP banks are extensive and extreme: compensation restrictions, severance limitations, incentive plan risk assessment and equity grant strategies.

Annual Incentives
It seems simple enough. No profits, no bonus. Not so fast! 
Given the under-performance of the banking industry over the last two years, there has been a decline in the number of executives receiving incentive awards. However, the amount as a percent of base salary for those receiving awards,  has remained about the same.
In this unprecedented recession, missing past performance targets does not necessarily result from poor management. Unfairness results by withholding executive incentive pay due to unmanageable catastrophic events. One-time events such as security write-downs or FDIC premium surcharges should be spread over several years to smooth out quantitative measures. Don’t forget that a well-designed incentive plan for IT, retail and commercial lenders should pay annual incentive regardless of bank profits.
The Board Compensation Committee will need to carefully assess overall bank as well as individual executive performance to determine whether awards should be paid. Positioning the bank for the future, growing the deposit base, growing and maintaining capital, managing liquidity and accomplishing key elements of the strategic plan are important considerations.
Community banks’ incentive plans often provide for variable awards based on the accomplishment of several critical measures and objectives. The measures are both quantitative, such as financial or numeric, and qualitative, such as discretionary or judgmental.
I suggest increased emphasis on incentive awards based on qualitative measurement of executive performance. Today’s economy will create rapid change due to uncertainties. Change also creates opportunities. The flexibility, vision and focus of the top executives can be measured subjectively by the committee. In many cases, the rapid repositioning of the bank’s business strategy in the face of change is as important as quantitative measures such as profit or share price during the financial crisis.

Examples of Qualitative Executive Measurements:
Careful evaluation of opportunities: residential mortgage lending, portfolio diversification, loan growth and noninterest income.
Targeting and executing a merger or retail location purchase.
Face time with key customers, employees.
Timely board communication and education.
Leadership and war room tactics to take prudent risks.   
Boards must recognize that executives will be called upon to be nimble, adaptive and responsive in the new economy. Now is the time to step up and encourage as well as reward executives to think outside the box.
To accomplish this, I recommend actively splitting executive annual incentive plans into a combination of annual and long-term awards.

Long-Term Incentive Plans
Implement Long Term Incentive Plans with discretionary awards that will vest in three years and pay out deferred cash compensation. The awards should target longer term bank strategic growth objectives and can incorporate three year rolling measurements. Additionally, LTI awards can appreciate based on increasing bank capital (phantom stock), a cost effective alternative to richer SERPs and an alternative for non-stock banks competing for executive talent with stock banks.
Retention and Hiring Bonuses
Special retention bonuses can be awarded to key executives (commercial lender, retail and IT) to ensure attraction and retention – just make sure those executives do stay by designing effective deferred compensation strategies.

Qualified Retirement Plan
Defined benefit pension plans can be frozen, terminated or benefit formula reduced. The aging workforce will increase pension costs, exacerbated by shorter government mandated accounting of unfunded liabilities, such as seven years versus 15 years regardless of investment earnings.
If your bank can afford it, remember that a defined benefit pension can be an attractive tool to recruit mid-career employees from competitors. The key is to redesign the pension formula to be cost effective: lower benefit formula, shorter career, etc. Remember, you can unfreeze a frozen pension at a later date!
Bank 401(k) matching can be reduced above safe harbor levels with emphasis on discretionary profit sharing contribution based on profitability.

SERPs
New cost effective performance SERP designs with an annual bank defined contribution as opposed to a compensation inflation-expensive defined benefit, can be implemented. These plans can include additional discretionary contribution based on bank profitability. A new trend to attract a stock bank executive to a nonstock bank is to buy out underwater stock options through SERPs. Use a SERP contribution to attract a commercial lender or retail executive with a book of business. SERPS can be a substitute for lack of stock options and used to defer both short and long-term incentive payouts.
The SERP accrual accounting methodology qualifying as a plan of deferred compensation may be converted to FASB87 from APB12 actuarial accounting methodology to possibly reduce bank annual expense.

Medical/Dental Insurance
Health insurance plans can be more cost effective by providing a bank annual defined contribution, not percentage of premium to health plans with the employee paying the difference in premium based on plan election.
Workforce Reduction
Workforce reduction by attrition, or quiet layoffs, can be accomplished by not replacing some employees who voluntarily terminate. Banks can also increase the use of part-time employees. Many baby boomers may want to hold onto bank jobs to supplement investment losses in their retirement savings. This will complicate management succession plans as well as drive up employee pension and medical costs for years to come. Selective early retirement window incentives can be designed to counterbalance baby boomers who remain employed.

Change-in-Control
Implementing standard “double trigger” change-in-control agreements for key management with severance varying by position is necessary for retention. The “double trigger” requires two distinct events to occur in order to accelerate payments: for example, both a change in control via a merger or acquisition and the involuntary termination of employment as a result of the change in control.
This benefit is critical for all banks in today’s industry consolidation phase. In the event of a change-in-control, IRS 280G Excess Parachute payments should be capped at $1.00 less than the IRS maximum limit to avoid loss of bank compensation deductions and executive excise tax. Excess Parachute payments include accelerated compensation, severance and SERP benefits that exceed three times the executive’s average W-2 pay over the prior five calendar years.

Director Retirement Plans
Director retirement plans for nonstock banks are necessary to help a bank retain, motivate and attract new directors, as well as promote healthy turnover on the board while allowing a director to retire with dignity. This can be a substitute for stock options, restricted stock and other equity awards for nonstock banks. Mandatory retirement age and term limits can be designed.
Nonstock banks’ director retirement plans may support the attraction of other community bank merger partners and help eliminate redundant or unnecessary director positions. In my practice, I implement director “early retirement windows” in tandem with retirement plans.
Conclusion
CEOs at high-performing banks earn more in realizable compensation than their low-performing peers and should continue to do so. Even today, compensation committees can continue to provide the compensation tools necessary to attract, reward and retain their best talent. Plan design changes are appropriate as outlined above, but compensation committees of strong banks need not succumb to panic, uninformed public pressure or hypercritical Washington bureaucrats. To do so may inadvertently destroy a bank’s franchise value.

Arthur Warren Esq. is a specialist in executive compensation and benefits planning. He has more than 30 years experience in the design and administration of compensation, benefits, perquisites and employment arrangements with over 100 community bank clients. He can be reached via e-mail at arthur@afwarren.com or at 508-660-0280. His Web site is www.afwarren.com.


Posted on Tuesday, July 07, 2009 (Archive on Monday, October 05, 2009)
Posted by Scott  Contributed by Scott
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