The article below was originally published in the July/August 2013 edition of The Texas Independent Banker Magazine.
Trends in Compensation – 2013 and Beyond
By Kelly W. Earls and Kathy Orr Smith
As a result of the upheaval in the financial industry dating back to 2007-09, and as with most of the subsequent legislation, the community bank market has taken the brunt of the unintended consequences. This is no different in the area of compensation.
Beginning with: (i) Internal Revenue Code Section 409A effective January 1, 2005; (ii) the Troubled Asset Relief Program Standards for Compensation and Corporate Governance, as amended, originally published as an Interim Final Rule by Treasury on October 20, 2008; (iii) Securities and Exchange Commission Proxy Disclosure Enhancements effective February 28, 2010; (iv) Interagency Guidance on Sound Incentive Compensation Policies enacted on June 25, 2010 (“Interagency Compensation Guidance”); and ending with: (v) the Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) signed into law on July 21, 2010; the federal government has promulgated a flood of laws, regulation, and rules relating to the delivery of compensation within companies, but more directly within financial institutions.
What is interesting is that there was a time when incentive compensation within the banking industry was considered by regulators as superior and a means to curtail fixed compensation costs (aka “salary creep”) in banks. Banks were, shall we say, encouraged to consider adopting some form of incentive compensation and move away from a structure of salary and discretionary bonus that typically amounted to one month’s salary. While compensation practices and payments have always had to fall within safe and sound banking practices, incentives, improperly structured, brought on problems.
Some banks learned by doing this, during the mid-1990s, that incentive compensation structured only to promote growth, particularly growth in the loan portfolio, was dangerous, especially if the incentive payment was immediate or shortly after year-end. Some banks had the privilege of paying out very large incentives during the first couple of years of implementation, but then later having to terminate the personnel for adding what turned out to be bad loans to the bank’s portfolio. Another issue that banks had to deal with was the moral issues that cropped up if the bank felt the need to change the incentive structure. Participants often would come away feeling that their employer only made changes because the bank decided that the incentive ended up creating too much benefit and needed to be diluted.
As a result, for a time after the mid-1990’s, many banks were reluctant to delve into incentive compensation. As we have worked with banks since that time, more and more have been open to implementing annual incentives and deferred incentives so long as the structure implemented addresses four key issues:
Be flexible so that the incentives can/will be changed to address the current needs of the bank;
Address both short-term and intermediate-term risk associated with the incentive;
Mitigate, as much as possible, any potential negative moral effect to the participants should adjustments be required; and
Be compliant from a regulatory standpoint
For a bank to have an incentive structure that provides flexibility, it is paramount to establish strong communication with the participants that emphasizes incentives and goals are annual in nature and that at implementation as well as each year thereafter, the participant should understand that the incentives absolutely will change based upon the environment the bank is operating in and the current needs of the bank. Banks can communicate this by the old adage: “tell ‘em what you are going to tell ‘em; tell ‘em; and tell ‘em what you told ‘em.” Having a group meeting to generally convey the parameters of the program and the expectations participants should have is the first step. That meeting should be followed up with individual meetings with communication pieces that set forth each individual’s specific incentives; and, in that meeting reiterate that the incentives will likely be different a year from now.
Risk with incentives has really been a hot topic with the regulators over the last 6-7 years. It began with TARP where everything from bonuses to stock options was prohibited so long as TARP funds had not been repaid. The Interagency Compensation Guidance then conceptually mandated that reward should be “matched-up” to the risks the incentives might promote. Generally, the guidance set forth the expectation to have some incentive compensation “at risk” to the participant. Included in the guidance was the recommendation that incentive compensation be subject to claw-back should loss occur from the incentive. Additionally, some of the incentive should be subject to deferral.
As a result of the guidance, many of our clients that want to maintain utilizing incentive compensation request that we assist in modifying their incentive compensation program. In doing so, we first examine each job eligible for incentives to determine what quality control measures may need to be added. Once that is completed, we also look to add a short-term deferral feature to the existing program. Again, communication of these changes to the participants is key. We mitigate the negative connotation of the changes by explaining that the Incentive Compensation Guidance as well as the passage of Dodd-Frank requires the synchronization of the risk vs. reward of incentives. Further, while a portion of the incentive is deferred, often it will earn a favorable rate of return which is established by the compensation committee and approved by the board of the bank.
However, with the advent of the Mortgage Lending Compensation rules under Dodd-Frank, another issue cropped up. As you know, Dodd-Frank has mandated that for those who are involved in making a consumer loan secured by a dwelling there are really only two avenues to compensate based upon that activity. One method of compensating directly from the activity is to pay some incentive based only upon the dollar volume of loans. The other method is to compensate based upon the volume of transactions performed. The issue that became apparent last year was that if those individuals were incentivized generally from the overall performance of the bank outside of a contribution to the bank’s qualified plan (i.e. a profit-sharing contribution), then these individuals would be found to violate the mortgage lending compensation rules through a proxy analysis. The logic goes something like this: paying an individual, who was involved in the mortgage activity, on the overall performance of the bank was paying them based upon the profits of the mortgage loans which are a part of the overall profitability and performance of the bank. As one can see, this is a very broad interpretation of the mortgage lending compensation rules. In order to comply, what seems to have alleviated the problem is to make one of the following adjustments:
Separate out mortgage revenue from the overall bank performance.
Do step 1 and use one of the two methods that are appropriate to pay on mortgages mentioned above.
Revert to discretionary compensation to disconnect any incentive from the mortgage activity.
Fall within the limited activity exception (either: (a) annual benefit less than 10 % of compensation; or (b) less than 10 mortgage loans a year).
Even without the new regulations, it seems more banks are looking to short-term deferrals for the purpose of retention as pay for performance has become a more significant component of compensation packages of key hires.
While deferred compensation for key personnel has existed for decades now, how that deferred compensation is being structured has changed a fair amount. During the boom years of the mid-1990s to the mid-2000s, individual defined benefit arrangements for key employees were probably the most widely instituted. These plans were commonly known as Supplemental Executive Retirement Plans (SERPs) or Salary Continuation Plans (SCPs).
However, since the financial crisis, many banks are looking to other alternatives when it comes time to include the next crop of executives into some sort of deferred compensation program. In addition to still utilizing SERPs or SCPs, some banks are exploring using defined contribution structures. The reason for this is simple. With a defined benefit program, the bank is required to make liability accruals every year to the balance sheet for the SERP or SCP, which has with it a corresponding expense as well. Since the banking industry has recently gone through a period of struggle, being required to make deferred compensation accruals in a year where the bank may not be performing as accustomed has been difficult. So, by having a program that defines the contribution, the bank can have better control of determining when an accrual to the deferred compensation program occurs.
While there is more regulation to comply with following the financial crisis, if structured properly, banks can still implement creative and customized compensation programs unique to their institution to achieve retention, recruiting and rewarding of their key employees that help the bank be successful.
Kelly W. Earls J.D. C.P.A is Principal and Kathy Orr Smith is President of Bank Compensation Consulting, Inc.