inform. educate. connect. Issue #9 - August 2010

Final Guidance on Sound Incentive Compensation: A New Day for HR Executives

By Gayle Appelbaum, Amalfi Consulting

As everyone knows by now, on June 21, 2010, the Federal Reserve Board, FDIC, OCC and OTS collectively issued final guidance on sound incentive compensation arrangements that apply to all banking organizations. This guidance is principles-based, and does not contain specific rules of what can and cannot occur in incentive plan design. There are no formulas, caps, or restrictions on types and amounts of compensation. The guidance is now in effect and will be a focus of regulatory exams. Banking organizations that do not use incentive compensation are excluded from these regulations. Also, covered employees include senior executives, individual employees whose activities may expose the organization to material amounts of risk, and groups of employees who are eligible for incentive compensation and who, in the aggregate, may expose the bank to material amounts of risk. Tellers, data processing personnel and bookkeepers may be outside the scope of the guidance, with nearly everyone else who is eligible for incentive compensation included.

What does this mean for Human Resources executives? First, each bank needs to create an inventory of all of its incentive compensation arrangements. TARP participants learned that this is not always an easy undertaking. The number of plans in some organizations is surprising, and there may even be plans in place that have been forgotten. Even if you do not anticipate paying out incentive awards from some of your plans, include them in your inventory. 

Next, prompt action must be taken to review all incentive compensation arrangements and make changes as needed. The guidance states that there is no “one size fits all”, thus, whatever a neighbor organization may be doing on this front may not be right for your bank. Also, the regulations are as yet untested, so it is not specifically clear what may cause a problem for your bank come exam time. Importantly, a bank that is found to have incentive compensation arrangements that pose a risk to its safety and soundness may be the subject of enforcement action; hence, the stakes may be high. 

The review of the incentive compensation arrangements should involve HR, the bank’s risk officer, and the compensation committee, or board of directors if such a committee does not exist. Risk management personnel should have input into the processes for designing incentive compensation arrangements and assessing their effectiveness in restraining risk-taking. If it is determined that changes are required to mitigate potential risk, then plans should be modified accordingly. In preparation for regulatory exams, be certain to document your processes, parties involved, findings of the reviews, modifications considered and made, and any other action considered and/or taken.

What do the regulations suggest about methods of bringing balance to compensation plans? Four methods are discussed that could be used to make compensation more sensitive to risk. These include:  risk adjustment of awards, deferral of payments, longer performance periods and reduced sensitivity to short-term performance. Risk adjustment of awards takes into account the risk employee activities may pose to an organization. For example, if two producers deliver the same results but one’s activities pose greater risks to the bank, then individual awards should be adjusted to reflect this. Deferral of payments delays the actual payout of an award significantly beyond the end of the performance period, thereby adjusting payouts to reflect actual performance results realized during the deferral period. Specific recommended deferral periods are not provided in the regulations, but mention is made of one year, two years or longer. Longer performance periods would extend the time period covered to determine actual performance results; it is suggested that some or all risk outcomes would be realized or better known by employing this method. Finally, reduced sensitivity to short-term performance reduces the rate at which awards increase as employees achieve higher levels of relevant performance measures.

What do we know at this point? The regulations cover all incentive compensation, both cash and equity-based.  Immediate action is required on the part of responsible parties (HR, risk management personnel, compensation committee) as the Federal Reserve stated that it expects as many as 1,500 banking organizations to spend material time reviewing and modifying their policies. It is anticipated that incentive compensation changes will be effective for 2011. Risk management personnel’s incentive arrangements must be based primarily on achievement of objectives of their functions rather than how the bank is performing. On-going monitoring is required of incentive compensation awards, payments, risks taken, and actual risk outcomes. The board of directors is ultimately responsible for ensuring that the incentive compensation arrangements for all covered employees are appropriately balanced and do not jeopardize the safety and soundness of the bank. The board and/or compensation committee should have access to external resources with expertise and experience in risk-management and compensation practices in the financial services industry. As with any guidelines, best practices and trends will emerge over time, particularly after we have been through an exam cycle.

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