Incentive Compensation: Back in Balance

By Henry Oehmann and Jim Pulsipher, Grant Thornton LLP

Author Ayn Rand once wrote, “Money is only a tool. It will take you wherever you wish, but it will not replace you as the driver.” Financial institutions have been using compensation as a motivational tool to boost employee performance and retention rates. However, after a challenging year and new executive compensation rules from the Treasury, financial institutions need to reconsider the way they drive incentive compensation.

Before you sign that check…
As part of the Emergency Economic Stabilization Act, the Treasury has issued new executive compensation rules for those financial institutions that participate. If an institution sells more than $300 million as part of the Troubled Asset Relief Program, it cannot enter into new executive employment contracts that include golden parachutes for the term of the program. In addition, the financial institution cannot deduct executive compensation in excess of $500,000 for each senior executive for tax purposes, nor can it deduct certain golden parachute payments. A 20-percent excise tax will be imposed on senior executives for golden parachute payments.

Financial institutions participating in the Capital Purchase Program face stricter rules regarding executive compensation during the time the Treasury holds equity issued under the program. In addition to the prohibition of golden parachute payments and the deduction of payments in excess of $500,000 for tax purposes, other conditions for financial institutions include:

• ensuring incentive compensation for senior executives does not encourage unnecessary risk or threaten the institution’s value and

• making a required clawback of any bonus or incentive compensation paid based on statements of earnings or other criteria that are later proven to be inaccurate.

What’s fair?
Although rescue programs have a great impact on the compensation programs of participants, fair value has a sweeping effect on all financial institutions. The fair value measurement of impaired assets has resulted in additional write-downs, dragging down the balance sheet. When compensation is based on revenue and earnings, objectives like earnings quality, credit quality and asset quality can take a back seat. In the midst of reduced revenues and impeded growth, the typical income statement-focused compensation plan should give way to an alternative approach: a compensation plan that is focused on the balance sheet.

Institutions must now be especially attuned to earnings and asset quality, instead of only revenues, when deciding rewards. Compensation plans that balance performance measurements with qualitative measurements are best equipped to address the challenges of the current climate while still fulfilling their purpose. As you plan a shift from the income statement to the balance sheet, focus on the objectives of stronger earnings, risk adjustment appropriateness and capital adequacy.

Loans: quality, not just quantity
There has been speculation that incentive compensation agreements that were based on volume (and the revenue and fees from that volume) pressured loan production offices to shortcut their processes for ensuring asset quality. These shortcuts have contributed to current non-performing and defaulted loans.

Now more than ever, long-term performance measures are vital components of new incentive compensation plans. However, they can not simply be viewed through a quantitative lens. Monitoring the frequency of non-performing assets is not as important as determining how to improve asset quality evaluation. All too often, as loans were provided in risky areas, the returns may not have been commensurate with that risk adjustment.

Loop in members of the board who are involved with asset quality to help create a solution. For instance, institutions could follow up on the application process and the rating and scoring process of the loan itself. Incentive compensation arrangements should also be enabled to retain any income gained from the revenue objectives of past years in the event of declining asset quality.

Withhold capabilities
Many incentive compensation arrangements based on a short-term approach were paid as frequently as semi-annually. These arrangements should be subject to claw-back features in which if loans are impaired, the incentive compensation that has been paid out would be paid back to the company. Or, if there was a withhold of that amount, it would be forfeited year after year, based on the amount that was withheld.

The loan approval committee and mortgage lender should share in the responsibility of the forfeiture – often, the mortgage lender suffers the brunt of the performance failure. A possible decline in loans, revenue and asset growth may be the trade-off for shoring up the balance sheet and bolstering asset quality and capital adequacy.

In today’s environment, financial institutions are charged with staying abreast of ever-changing developments. As regulators and stakeholders alike demand more transparency, incentive compensation plans move front and center. Assessing your compensation plan on an ongoing basis to ensure compliance pays off.

<back to January 2009 Directors Digest>