By Arthur Warren
The fallout of the Great Recession requires changes in community bank compensation philosophies and plan design. Salary, incentives and benefit program features that were appropriate several years ago may now be unrealizable and at odds with current business objectives to increase profitability, become more efficient and better manage risk.
Federal legislation attempting to curb abusive pay practices is phasing in slowly. But federal and state banking regulators are extending new, unwritten risk management standards to community banks. Their focus is moving from reactive to proactive by looking at all types of risk facing banks.
How? Through routine safety and soundness examinations. As regulators begin to examine large banks, they also apply the new regulations to community banks. The regulations trickle down to the community bank level.
Regulators will focus on the pay programs of mutual banks. Stock banks, where public proxy disclosure and shareholder oversight are sufficient controls, receive less scrutiny. Regulators will criticize problematic pay and inadequate benefits governance at the community bank level. The criticism is a message and a warning: Correct your ineffective board governance.
Ineffective board governance manifests in many forms, including an unrealistic strategic plan; the CEO who runs the board; the board that runs the bank; weak executive management and excessive risk-taking.
Your strategic plan, business plan and compensation programs must support each other. Board members and compensation committee members must be knowledgeable of and involved in the planning process to comply with new regulatory scrutiny.
One bright shining star I see in the regulatory sky is a willingness of regulators to recognize the uniqueness of each bank in its geographical community. There is no prescribed right way. Instead, regulators apply broad principals to examine board governance and oversight of risk.
Base Salaries and Incentives
Salaries should reflect executive responsibilities, contributions and performance. The key role of incentive compensation is to encourage robust executive performance in achieving bank predetermined objectives and to do so without inappropriate business risk. Base salary and incentives should be balanced with all other elements of compensation, such as benefits, supplemental executive retirement plans (SERPs) and perks.
Regulators pay attention to incentives outside the 75th percentile of a realistic peer group. They want boards to align incentive pay with the time horizon of risk. Annual incentives should reward annual performance. Long-term incentives should reward performance over multiple years. Make sure incentive pay is not simply delayed executive base salary and is justified by added bank profits.
Executive incentive opportunity is a measure of risk. This risk can be controlled by utilizing multiple performance metrics; asset quality objectives; caps on awards; and different metrics for short and long-term bonus programs.
I expect that annual incentive bonuses will be more variable than in the past and perhaps a smaller part of executive total compensation. Long-term incentives may well play a larger role as a tool that both encourages long-term bank franchise value and mitigates risk by focusing on multiple-year goals.
There is a real risk that is being overlooked in smaller banks: Executive turnover in key positions is a risk aggravator. Conversely, a talented management team is a risk moderator. This underscores the importance of a well thought-out compensation and benefits program to retain and motivate senior executives and high potential talent.
In the slow growth economy, expect competitor poaching of your lenders or trust officers who can bring a book of business to a new bank. It is good board governance to protect bank assets that walk home at night. Turnover is costly, disrupting and damaging to smaller banks.
Let’s take a look at important executive benefit trends:
Increasing SERP participants, but shifting to defined contribution which follows the national trend of fewer defined benefit pension plans.
Eliminating perks which do not have a business purpose.
Increased use of employment contracts and change-in-control contracts due to impending consolidation in the banking industry.
Decreased severance, or providing severance with limits, to preserve the bank’s tax deductions.
Zero tax gross-ups for severance payouts.
SERPs continue to be a staple in the banking industry and are persistently wide spread regardless of asset size. In mutual banks, SERPs are an especially important deferred compensation tool to attract and retain executive talent and are a substitute for lack of long-term incentive stock and option awards. Additionally, many more mutual banks will need SERPs to make-up retirement shortfalls from the inevitable reduction in increasingly expensive core defined benefit pension plans.
However, traditional defined benefit SERPs are being frowned upon by shareholders, boards and some regulators because there is no apparent link to performance and executive pay inflation is increasing bank SERP costs.
The regulators criticize SERPs when the design allows for unreasonable compensation or risky practices, such as including a SERP benefit based on the highest calendar year base salary, a very rich bonus, or benefit payouts which extend too long in time.
Regulators also scrutinize SERPs when the design permits:
lack of SERP forfeiture in the event of executive termination for cause
understating bank SERP accrual liabilities
a present value interest rate discount that is too low when an executive receives a lump sum benefit rather than an annuity
SERPs work best when they are strategically designed to balance bank long-term compensation objectives and executive retirement security. There are two noteworthy SERP design trends.
Fixed percentage defined benefits without complicated offsets. An example is 20 percent of final average base salary. This is a simple formula to administer and avoids all the confusing actuarial projections of offsets like pension and 401(k) balance annuitization.
Defined contribution, which does not promise a target benefit. This follows the banking industry’s elimination of qualified defined benefit pension plans in favor of 401(k) account balance type plans. Each executive SERP account is administered by the bank’s 401(k) vendor or in-house on an Excel spreadsheet. These SERPs include modest, annual, fixed contributions, and board-approved, performance-based, discretionary contributions awarded for bank or individual executive performance.
This is a great substitute for long term incentive plans or lack of stock-based awards. Bank accounting liability is controlled as the bank only accrues the annual contribution expense which is not based on projected increase in executive pay.
In order to avoid negative regulator comment, or negative board, public and shareholder perceptions, perks are being curtailed.
Executives will indeed be receiving less supplemental post-retirement life insurance; legal or tax advice for spouses spousal travel; and tax gross-ups to buy perks.
Taxable auto allowances are replacing bank owned or leased cars which simplifies record keeping. Club dues must have a demonstrated business purpose.
There is no rough patch for executive employment contracts and change-in-control agreements, especially in mutual banks. Annual contract renewal (Evergreen) are the trend, but daily contract renewals or very long employment terms are discouraged. Change-in-
control severance agreements are proliferating in anticipation of future bank mergers.
All employment contracts should require the executive to sign a general release promising not to sue the bank, not to compete, and not to disparage in exchange for severance payments. The norm has been mutual releases by both parties but a single release strategy should be discussed, especially in light of evolving Dodd-Frank claw-back and whistle-blower rules.
When negotiating new employment contracts, you should consider the employment contract and change-in-control trends.
Bi-furcated severance: Lower severance payment for termination not-for-cause; higher severance for loss of job associated with a merger.
Single trigger: Severance payment upon a change-in-control when there is no loss of job is not advisable.
Double trigger: Severance payment upon a change-in-control plus a job loss is advisable.
Tax gross-ups: Both federal and state regulators discourage severance tax gross-ups as unreasonable compensation.
All new contracts: Change-in-control severance should be limited to $1.00 less than the IRS 280G excess parachute safe harbor limit. This preserves the bank’s tax deduction and eliminates executive excise tax.
Executives and boards are struggling with significant strategic business and financial issues that arise from their business models that were built based on their view of the world before the Great Recession. A vastly set of economic, business and regulatory rules exist today demanding new approaches to community bank compensation practices.