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Putting together pay plans after TARP E-mail

Understanding the impact on pay programs post-TARP
By Susan O’Donnell and Jinyoon Chung, Pearl Meyer & Partners. More about the authors at the end of the article.
Financial institutions participating in the Troubled Asset Relief Program have had to balance the need to comply with strict limitations on compensation while maintaining the ability to attract, motivate, and retain top executive talent--all during one of the most difficult environments in recent memory.

With companies now steadily exiting the relief program, it’s worthwhile exploring how TARP participants addressed the limitations, and what strategies they are using as they emerge from the program amidst an environment of continuously changing compensation regulation.

Many of the TARP restrictions have become applicable to all public companies,  particularly in the areas of risk assessment, clawbacks, Say on Pay, consultant disclosure, and Compensation Committee independence.

Subsequent guidance from the bank regulators, issued in June 2010, as well as pending Section 956 rules under the Dodd-Frank Act, ensure that pay programs will broadly continue to evolve in this direction.
How TARP covered bank compensation
In response to the financial crisis, Congress passed the Emergency Stabilization Act of 2008 and established TARP, which ultimately provided financial assistance to 766 companies (excluding auto makers). Multiple restrictions were placed on executive compensation practices at companies while receiving funds, most notably:

• Prohibition on paying or accruing bonus, retention, or incentive compensation for up to 25 of the most highly compensated individuals, depending on the level of TARP assistance provided.

• Prohibition on severance, including golden parachute payouts, for the top five executives or any of the next five most highly-compensated employees.

• Prohibition on tax gross-ups for the top five executives and the next 20 most highly compensated employees.

• Mandatory risk assessment of all employee plans.

• Mandatory clawbacks.

• Limit on grants of restricted stock to one-third of annual compensation.

• Reduction of the IRS tax deduction maximum under  IRC Section162(m)(5) from $1 million to  $500,000.
Cascading consequences of TARP
In response to TARP’s limits on certain pay practices, participants had been required to adjust their compensation programs, most notably by excluding cash incentives and remixing the salary and stock components:

• Larger banks faced with the most significant restrictions have relied on “salary stock” to ensure executives are adequately compensated.

• Smaller banks (e.g., below $3 billion in assets) were less likely to see total pay opportunity decrease, although the mix of compensation shifted from cash to stock-based vehicles.

However, some unintended consequences of TARP-compliant pay strategies also emerged:
• Higher CEO turnover. TARP banks experienced higher turnover than non-TARP institutions during the past three years. Of 80 banks with assets between $5 billion and $100 billion, of which half were TARP participants, turnover was 33% among the TARP participants and 10% among the non-TARP participants.

While TARP may not have been the primary reason for the turnover, we understand from anecdotal discussions that the restrictions made it more difficult to retain key executives.
• Difficulty recruiting top talent. Some boards and recruiting firms faced significant challenges in structuring competitive pay packages for prospective CEO and other senior new hire candidates within the TARP limitations.
• Higher salaries. To compensate for limits on the use of incentive-based pay, many TARP participants increased salaries in an effort to realign the pay mix and remain competitive.

Using the same data sample as referenced above, salaries at TARP banks increased 12% between 2009 and 2010, compared to 2% at non-participants.
• Reduced the alignment of pay and performance. TARP eliminated some common and effective tools used to motivate and reward employees--at a time when demonstrating a link between pay and performance was becoming more critical.
Post-TARP pay strategies
Although financial institutions that repay their TARP assistance can return to the more traditional components of compensation, most are taking the opportunity to rethink their compensation strategies and how to best define the mix and levels of pay to meet desired objectives.

Actions being adopted by banks that have repaid their TARP obligation have included:

• Eliminating salary stock,
if paid.

• Selecting new performance measures and making risk adjustments for short-term cash incentives.

• Redesigning long-term equity incentives to use more performance-based stock, longer performance periods (e.g. three years), and relative performance measures

• Revisiting employment contracts and change-in-control provisions to align with current governance practices, such as elimination of tax gross-ups and single-trigger change-in- control severance arrangements
Strategies to consider
We recommend the following strategies for companies preparing to pay off TARP--and any bank that wishes to remain competitive can learn from some of the same compensation introspection points:
• Recognize that acceptable pay practices have changed in recent years. Rather than automatically restoring former practices, understand that certain practices relatively common in the pre-TARP era are no longer considered appropriate.

For example, any executive incentive plans on hold during the TARP period should be updated to incorporate new risk-adjustment features. Allowing old contracts to renew with features such as tax gross ups or single triggers could result in negative votes from shareholders.
• Redefine your total compensation philosophy. Disclosure to regulators and shareholders requires a clearly defined compensation philosophy often requiring updates from pre-TARP days.

A well-defined compensation philosophy states the objectives of the total compensation program; the components and mix of pay elements; and competitive reference/benchmark positioning, as well as risk adjustment strategies and pay-for-performance approach.

For public companies, the compensation philosophy also is the foundation of the Compensation Discussion and Analysis (CD&A) on which shareholder Say on Pay votes are based.
• Review and redesign incentive plans. All banks should ensure performance-based programs adhere to new risk requirements and effectively align pay with performance. This requires rethinking performance measures and perspectives (e.g. absolute vs. relative); time horizons (annual vs. longer-term); mix (cash vs. stock); risk mitigators (including deferrals and adjustments); and policies/governance practices (such as board oversight and payment approvals).
• Reinforce a long-term performance perspective. In response to concerns that an overly short-term performance horizon among executives was a significant factor in the financial crisis, regulators want bank compensation programs more closely aligned with the risk horizon--which in situations such as credit risk on loans is significantly longer than one year.

Among the possible approaches to promote and reward a longer-term performance perspective: shifting more incentive opportunities toward long-term/multi-year performance goals; deferring a portion of shorter-term awards; embracing stock ownership policies; and instituting clawback requirements.
• Proactively review executive contracts and benefits. Once-common executive retirement plans and perquisites are being closely scrutinized by regulators and shareholders, while tax gross-ups, extra service credits for retirement benefits, severance payments in excess of 3x cash compensation and single triggers for change-in-control payouts (and walk away provisions) are no longer considered acceptable practices for TARP or non TARP companies.
• Promote a more balanced and holistic view of compensation. Banks should recognize that increasing or reducing any element of compensation changes the program’s overall mix and value.

A strong program maintains a balance between fixed and variable pay, short and long-term incentives, and formulaic and qualitative goal-setting.
• Use competitive market data carefully. Because it is by nature historical, competitive market data lags behind actual practices--particularly in a fast-changing environment.

Benchmarking should be only one of many considerations in developing programs or making pay decisions.
• Test program effectiveness and appropriateness. It is important to conduct ongoing analyses to help ensure compensation programs are not excessive, align with performance, and are effective in meeting desired objectives.

Tally sheets can be an effective tool to show the total compensation and benefits received each year. However, other analyses will provide a more thorough assessment. Examples include: model pay opportunity ranges under different performance scenarios to show the potential rewards that can be earned; assess realized pay to understand the actual value received (e.g. stock options and performance shares have no value until earned); analyze retention values (i.e. unvested awards) to assess whether you have retention “hooks” in your top performers; and regularly calculate executive stock ownership, which reinforces shareholder alignment and ensure  “skin in the game.”
• Plan ahead.  While it may be difficult to project exactly when TARP funds will be repaid, it is important to begin developing post-TARP compensation strategies at least six months prior to that, in order to ensure a smooth transition.

Looking forward
While TARP companies have been in the forefront of compensation regulation, new legislation and guidance, and evolving best practices require that all banks regularly monitor their programs for compliance and effectiveness. Additionally, Say on Pay requirements mean that public banks will remain under even greater scrutiny as shareholders’ voices (and votes) are heard.

The use of the analyses and perspectives discussed above can enhance every bank’s understanding of how well its executive pay programs are meeting strategic objectives and help ensure that the Compensation Committees is able to make a persuasive case to regulators and shareholders in support of the company’s executive pay programs, whether a TARP participant or not.
About the authors
  Susan O’Donnell is a managing director in the Boston office of Pearl Meyer & Partners.
  Jinyoon Chung is a vice-president in the Boston office of Pearl Meyer & Partners.

[This article was posted on September 23, 2011, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2011 by the American Bankers Association.]  
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