SUSAN O’DONNELL
‘Behavior’ motivation
Bank executive compensation plans have shifted from guaranteed stock options and retirement funds to performance-based pay initiatives, but industry analysts say that in the wake of corporate scandals that have rocked business culture and practices in the United States, such incentive programs must be replete with careful checks.
As competitiveness in the banking and financial services industry grows, banks are continually creating new ways to motivate their employees, say industry watchers. The latest wave of creativity involves finding ways to reward good performance without providing incentives to artificially inflate earnings reports or stock prices.
According to Susan O’Donnell, senior vice president and banking consultant at Clark/Bardes Consulting in Duxbury, the biggest trend in executive compensation at banks is still performance-driven pay, albeit in a more watchful mode.
O’Donnell tells her banking clients that performance-driven pay is “manifesting itself in all areas of executive compensation, including base salaries and short-term and long-term incentives.”
Base salaries, according to O’Donnell, are becoming more conservative and banks are more frequently using the overall performance of the bank at the end of the year and the individual performance of the employee to determine salaries and bonuses.
However, one complication banks face is differentiating the short-term and long-term incentives for employees and industry analysts are advising banks to motivate and reward employees based on pre-defined goals.
According to O’Donnell, 100 percent of banks with over $600 million in assets have annual incentives and only about two-thirds, or 66 percent, of banks with less than $600 million in assets have annual incentives.
“The purpose is to motivate and reward the achievement of pre-defined performance results and align and motivate behavior to support shareholder interests,” said O’Donnell.
Louise Levesque, senior vice president at Salem Five Cents Saving Bank, said the $1.3 billion-asset Salem Five is constantly reviewing compensation incentive plans and currently the bank offers several incentive plans, depending on the employee’s position at the bank.
Salem Five offers a management incentive plan, an incentive plan for those who work in the retail call center and another plan for the retail branch network.
Levesque said the plans range from short term to long term, but the overall objective for obtaining each plan is to meet the bank’s goals set at the beginning of the year.
“We have several incentive plans … the bank has certain objectives the bank wants to meet for the year and if the goal is achieved the plan is funded. Individuals participate based on achievement of their own goals that were set at the beginning of the year,” said Levesque. “It’s a ‘performance to pay’ type plan. We reward high-performing folks for their accomplishments.”
One way banks can safely link performance to pay is through virtual stock options, said Kevin Kaeding, president of Kaeding Ernst & Co, a financial services and employee benefits provider based in Marlborough who concentrates on incentives and benefits for community bank employees. Unlike traditional stock-option plans, which have been criticized in the wake of recent corporate scandals for inciting executives to artificially inflate stock prices, virtual or phantom stock options reward executives based on long-term stock performance without granting actual stock ownership.
“Compensation programs for stock banks very often differ meaningfully than co-op banks. With a stock bank you are going to find presence of stock options and direct and indirect compensation related to the increase in earnings per share. The mutual or co-op bank approach is that service to community usually outweighs desire for the return on equity,” said Kaeding, who developed a phantom stock plan that allows banks to offer rewards to top executives only if they meet the bank’s long-term financial goals and expectations. “The phantom stock objective can be very productive because it allows senior management to know that if they increase the bank’s earnings that they can participate in the success of the company” without direct ties to real stock options. “There is a manifestation of greed in America and it’s influenced [the passage of] the Sarbanes-Oxley legislation,” he said.
Kaeding said the idea of phantom stock is new to New England banks, but is slowly being embraced as a way for banks to keep a competitive, performance-based package in place for employees.
“Generally speaking, in any community bank you’re probably talking about a group of 15 people that make up key management members, but what is offered? You have to have a competitive base salary then you have to add to it the usual core benefit programs, including 401(k) benefits, financial planning add-ons, and so on. For senior management, the retirement issue becomes a very big deal, so phantom stock options can be an incentive for them to remain with the bank,” said Kaeding. “I’m guessing that in time we’ll see these phantom stock arrangements employed throughout most banks.”
‘Greater Scrutiny’
O’Donnell there is still a large focus on long-term incentives, but corporate governance plays a major role in defining those incentives. While there has always been a focus on performance-driven pay and incentives, she said the need for creative alternatives to the more traditional form of performance-based compensation is more pronounced because of “today’s increased scrutiny and corporate scandals.”
“Because of Sarbanes Oxley, fixed stock price options are expected to be expensed sometime in 2004 and there is no longer ‘free’ compensation,” said O’Donnell. “Stock options are major contributor to corporate corruption … and banks are looking at a more balanced approach and looking to allocate and reward equity based on performance.”
Sarbanes-Oxley also added an entirely new approach to employee compensation incentives, said one local attorney.
James Matarese, a partner in the merger and acquisition and corporate governance departments at Boston-based Goodwin Procter LLP, said Sarbanes-Oxley has added a whole new level to corporate compensation incentives.
“[Sarbanes-Oxley] is bringing greater scrutiny to the [compensation] process by the boards and the committees. We tell our clients … don’t make mistakes, and process, process, process is most important. Process is paramount,” said Matarese. “A lot of boards and compensation committees still just don’t get it. In this environment, most people on these boards realize that business as usual is not going to work anymore. Now, you have to look at business processes with respect to compensation.”
O’Donnell said corporate governance plays an important role in compensation committee roles, and since the legislation was enacted there have been increasing demands on compensation committees.
“There is more responsibility, risk and accountability,” said O’Donnell. “[Compensation] committees can’t afford to say ‘I didn’t know.'”
O’Donnell said compensation committees need to create a philosophy that explicitly defines their roles and responsibilities to the bank and bank employees.
“The compensation philosophy will serve as a framework for guiding [the committee’s] oversight and it also provides a consistent message to shareholders, management and executives. It [ensures a safe] pay-for-performance philosophy,” said O’Donnell.
Regardless of the type employee compensation, O’Donnell said banks need to define their “compensation philosophy.”
“[Banks need to decide how] they are going to align compensation to performance and which elements of compensation are needed to meet their objectives,” he said.
Most importantly, said O’Donnell, is fitting the right mix of compensation packages with the right employee group.
“If all your compensation is in long-term, retirement-=oriented compensation, you are rewarding people for staying, not necessarily performing,” said O’Donnell. “When those people leave, you don’t have a compensation program that will effectively attract and retain new executives.”
