Citigroup, Inc.’s New CEO Compensation Plan

Citi is finally getting CEO pay plans right! After losing their shareholder “say-on-pay” vote at the 2012 Annual Meeting of Shareholders, new Chairman Michael E. O’Neill, who just took over as Chairman last April, interviewed a large number of important shareholders. He was told that paying their CEO a $6 Million Incentive based on a two-year (2011 and 2012) cumulative pre-tax profit of $12 Billion, may sound like a good deal for the shareholders, but it was fraught with problems.

carrots

Incentive Pay Must Be Carefully Designed

To begin, the Company had 2010 pre-tax profit of approximately $12 Billion. So, the hurdle for earning the $6 Million was half of the actual earnings in 2010. Yes, the economy has made earnings difficult to produce, and yes, Citi is trying to overcome internal problems, but shareholders were unwilling to allow a hurdle rate that low. There were other problems with the design of the Plan.

Cumulative two-year pre-tax earnings ignores the fact that the bank could grow assets at a decreasing return on each dollar and meet the earnings hurdle while increasing their capital requirements significantly. Using volume of profit as a management performance measurement always has this inherent problem. In fact, increasing volume of profit can and often does result in lower returns on equity in banking. For that reason, shareholders can lose as management earns more, and a lose-win plan is never good.

Finally, building on the last point, there is no clear link between shareholder returns and management pay in the Plan Citi was using. A common objective of executive compensation plans is to align the interests of management with those of the shareholders. The old Citigroup, Inc. Plan did the opposite to some degree. The Board of Citigroup consists of intelligent and successful people, but they got some bad advice along the way. After Chairman O’Neill spoke with shareholders, he tasked the Board’s Compensation Committee to redesign the CEO’s Compensation Plan to address the shareholders’ concerns. He was not about to get a negative “say-on-pay” vote after his first year as Chairman.

Now, in my many years of studying and designing executive compensation plans, I have yet to see the perfect plan. It just does not exist. Business is too complex to allow for such a thing, and the need to keep the plan as simple as possible is an important constraint.  Yet, the new Citigroup, Inc. Management Compensation Plan addresses shareholder concerns with an elegantly simple design.

Executives will be granted units worth a certain amount in three years if certain performance is achieved.  Citigroup stock must perform in the top three-quarters of a carefully selected peer group of stocks of similar companies, and Citigroup’s Return on Average Assets over the three years must beat a hurdle equal to the previous year’s actual or there will be no units rewarded.  Furthermore, if the Return on Average Assets over the three years is better than the previous year by a significant percentage, then a target number of additional units will be awarded.

This design is superior to the old design because it clearly:

  1. aligns management’s interests with those of the shareholders and
  2. it is tied to relative performance compared with peers as well as the Company’s strategic goals.

There are some potential draw backs to such a plan, but the new plan is so much better than the old plan, I will not spend words on the risks in this particular blog.  Perhaps in the future, we can look at some of the potential flaws.  In the meantime, I say congratulations to Mr. O’Neill.  I may go buy some Citigroup stock!

Effective Strategic Planning in a Challenging Environment

Change?  No change is necessary.

That is what some bankers thought when their institutions began to suffer the first shocks of a quake that started rattling the financial industry in the mid-1980s.  These bankers figured that if they just hunkered down and minded their own business the tremors would subside.

Bank Strategic Planning

Bank Failures Since 1979, Source: SNL Financial and FDIC
Number of Failed Banks in 2012 is annualized based on 23 failures as of 5/1/12

Instead, many banks – and bankers – vanished.  From 1988 to 1992, the U.S. banking industry witnessed more bank failures than ever before, especially in any comparable five year period.

The reasons were complex.  Massive change hammered the industry.  New banking laws and regulations altered how financial institutions could do business and increased base-line costs.  For banks that were already on shaky financial footing, new capital requirements dictated cutbacks and/or injections of hard-to-find investment dollars.  The debut of interstate banking intensified price-cutting campaigns to win market share, and margins began to shrink.

Sound familiar?  It’s de ja vu all over again!  “Same events, different time.”  The earthquakes returned in 2008, and the financial world began to come undone once again.

For survivors of repeated quakes, reality has arrived.  If we hope to retain our jobs and help our institutions withstand external pressures, we had better prepare for life in an earthquake zone.  Strategic Planning is needed today more than any time since the 1980’s.  Through strategic efforts, banks can intelligently re-engineer their institutions to gain the resilience and strength needed to absorb shocks – and even expand – in our unstable economy.

Strategic Planning is extremely challenging in this environment, since it requires looking at the future and making assumptions.  Today, about the only given is that more massive change lies ahead.  Yet, an outline is emerging of the future that banks will face.  Over the next four or five months, we will comment on dealing with specific trends.

The Risk of Becoming Risk Averse in a Post Financial Crisis World

Some Federal officials and others from sectors that are removed from day-to-day commerce want to blame risk takers, represented by Wall Street investment bankers, for high unemployment and frozen financial markets, and certainly risk exploded during the decade leading up to 2008.  While Wall Street firms need to bear their share of the responsibility for participating in risk-run-wild, there is plenty of blame to go around, including government policies before and since the liquidity and credit crisis hit in late 2008.

It is important now to fully diagnose the reasons for our recent economic woes and pass regulation that helps identify the size and nature of systemic risk in the future.  It needs to start with governmental policies, federal, state and local, that interfere with the normal market-driven risk and reward mechanisms that have controlled free enterprise from its inception.  Risk rating agencies need to be truly independent in the future.  Corporations must do a much better job of assessing the risks they create or support in the marketplace.  In addition, American consumers need to be better educated in economics and free enterprise so that they can detect risk in offers that are too good to be true.

FDR is often quoted as saying in his first inaugural address, “The only thing we have to fear is fear itself.”  We need to remind ourselves of this wisdom in these times of frozen job markets and banks.  One of the primary tenets of capitalism is “no risk, no return.”  Fear of risk has things frozen.  It is time to take measured risks again, not the senseless risks we saw in the mortgage funding government policies or mortgage-backed securities that could never have produced a lasting return, but reasonable risks that produce reasonable, long-term returns.

Sharp Edges

Misguided Warning

One of our greatest risks at this point in the history of our great nation and its great economy is, as FDR put it, the “nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”  We risk becoming so risk averse that we will never move ahead.  Government needs to stop punishing and get out of the way of growth.  Banks need to make loans in support of reasonable new ventures.  The unemployable must learn new skills.  Corporations need to expand and hire people to grow their businesses.  The global market will make a comeback if we don’t let our fears of risk prevent it.

Executive Pay Equity

A recent headline from WorldatWork indicates the gap between CEO and CFO pay is growing farther apart.   The study conducted by BDO USA, LLP indicates that CFOs average 40% of CEO pay at 600 public companies included in the study.  One reason offered for the increased disparity is due to CEO pay being more commonly tied to the increase in the company’s equity, which for most public companies, increased substantially in 2010 and 2011.

While CEO’s have historically been paid at levels higher than the rest of the executive team, this recent trend of an increased gap could lead to problems.  Shareholders may assume that the change in the CEO – CFO pay comparison could be a reflection of how the Compensation Committee values the relative roles of risk-taker vs. risk-controller.   Let’s hope not.  That led to some serious problems in the past.  It is more likely that the bigger recent gap is due to the 2010 and 2011 run up in stock prices and the CEO’s larger percentage of compensation tied to stock price gains.  Should the mix be so different for the two positions?  A return to a more equitable internal pay structure will help avoid potential perceptions among shareholders that CFOs are not valued as much as they have been in the past.

With slowly improving economic indicators, organizations are reviewing current compensation practices.   In addition to the scrutiny on executive compensation as a Pay Equityresult of Dodd-Frank, this renewed focus on executive pay will require organizations to focus on their philosophy and implement equitable compensation plans.  Compensation Committees may want to look at how relative compensation has changed over time and consider ways of optimizing compensation mix to stabilize the fluctuation in the comparisons.

In our Firm’s work with client executive teams, we have historically measured the internal pay equity of senior executives measured as a percentage of the CEO’s pay.   We have significant, historically viable data showing the relative pay for all executives on the senior team as related to that of the CEO.   Two critically important objectives of any company’s compensation philosophy should be to target external competitiveness and be internally equitable.

If you would like a review of your company’s current compensation practices measured against market, industry and custom peer groups, please give us a call (919-644-6962) or visit us at http://matthewsyoung.com.

Ideal Community Bank CEO Candidate

Needle in a Haystack

The Community Bank CEO of the future may be hard to find

Today’s “American Banker” had an editorial called “Chief Factor in Small-Bank Survival? It’s the Chief.”  No question about it!  Leadership matters and while the banking industry has always been about people, the quality of the leadership has never been as critical.

The model for success in the future for community banks is changing radically.  Margins will be thinner on the traditional business of gathering funds and lending them out.  Costs for doing business are rising, if for no other reason than increasing regulation.  Customers are shifting banking habits requiring banks to invest more in technology-based solutions.  The challenges to success will be sizable.  So, what does the ideal candidate profile for the future community bank CEO look like?

I am sure we don’t yet have all of the answers to this major question, but many of the features can be seen in other industries that have gone through massive change.  Retail distribution went through similar change over a couple of decades leading to the development of big-box and chain retailers taking the place of the local hardware store and clothier.  Some leaders saw the change coming and innovated.  Some changed the channel of distribution.  Some narrowed the definition of their niche.  In every case, survival depended on strategic vision, detailed knowledge of their communities and customers and the leadership abilities to take their people through the wrenching change without destroying their loyalty.

The ideal community bank CEO of the future will need to have a wide array of skills and abilities.  They will need a mix of technical skills and interpersonal abilities that may be difficult to find.  Technical skills to recognize and analyze risk and understand the opportunities and the limitations of technology will be key.  In addition, the leadership traits of visionary strategists and change agents will be essential.  The CEO of the future will also need to be able to drive a sales culture and hold people accountable for results.  They will need to be a community leader and a master politician to help the local community understand why he or she demands performance and is willing to turn over staff members that may be their neighbors.

We build “Ideal Candidate Profiles” for Boards who ask us to find executives, and while every organization has its unique needs, there are certain traits that are usually needed based on the executive position.  We are exploring the changes needed for the future and the community bank CEO profile is one that will change dramatically.  Click the button below and register for a free presentation to your Board about the CEO of the future, or call 919-644-6962 and ask for Tim.

Request your Free Board Presentation

Succession Planning Without Three Envelopes

According to a recent WorldatWork survey of large companies, over 30% have no succession plans in place and 50% of executives say they do not have a successor for their current role.  Why?  They cited a number of reasons:

  • Not enough opportunities for employees to learn beyond their own roles (39%)
  • Process isn’t formalized (38%)
  • Not enough investment in training and development (33%)
  • Not actively involving employees or seeking their input (31%)
  • It only focuses on top executives (29%).

A lack of succession planning can lead to a lack of strategic direction and weakened financial performance, but it is hard work and Boards tend to make it a task instead of a strategy.  We will be happy to share an outline of succession planning as a strategy.  Just go here and request it:  http://matthewsyoung.com/contact.htm

The three envelopes for succession planning

The three envelopes for succession planning

Or, you could use the three envelope approach.  I learned this approach from a fellow who had just been hired as the new CEO of a large, publicly held company.  The CEO who was stepping down met with him privately and  presented him with three numbered envelopes. “Open these if you run up  against a problem you don’t think you can solve,” he said.

Well, things went along pretty smoothly, but six months later, the net interest margin  took a downturn and he was really catching a lot of heat. About at his  wits’ end, he remembered the envelopes.  He went to his drawer and took  out the first envelope.  The message read, “Blame your predecessor.”  The new CEO called a press conference and tactfully laid the blame at  the feet of the previous CEO.  Satisfied with his comments, the press – and Wall Street – responded positively, the stock price began to pick up and the  problem was soon behind him.

About a year later, the company was again experiencing a slight dip in  margins, combined with serious balance sheet problems. Having learned from his  previous experience, the CEO quickly opened the second envelope.  The  message read, “Reorganize.”  This he did, and the stock price quickly rebounded.

After several consecutive profitable quarters, the company once again fell on difficult times.  The CEO went to his office, closed the door and opened the third envelope.  The message said, “Prepare three envelopes……….”

You don’t need three envelopes if you use succession planning as a strategy.  http://matthewsyoung.com/contact.htm

Be prepared for a DOL Compensation Audit

DOL Compensation Audit

Are you ready for a Compensation Audit?

We have been contacted over the past 6 months by a number of large employers across the southeast, who have recently experienced a compensation audit by the U.S. Department of Labor.  Key parts of these audits have been requests for documentation on the Company’s compensation policies and information to support how the Company’s practices match policy.  Key areas reviewed included overall compensation policy, base compensation, distribution of salary adjustments, incentive plan structures, and FLSA compliance (interestingly these audits do not seem to have targeted ERISA or other key DOL areas).

As with any audit, preparation is always a “best practice”. If you have questions about what being compliant means, if we can assist you with an audit of your  current pay practices, and/or if you need help developing policies and processes that match Company intent and are legally compliant, please contact us at 919-644-6962, or complete a contact request at http://matthewsyoung.com/contact.htm.

How to Do a Compensation Plan Risk Assessment

The SEC, US Treasury and jointly for banks the Federal Reserve, OCC and FDIC in a joint agency statement have made risks in compensation plans a high priority and point of emphasis.  Furthermore, SEC proxy disclosure requirements for 2010 require an explanation of the relation between compensation plans (primarily incentive compensation) and risks that may be more encouraged due to motivations caused by such compensation plans.  Specifically, these regulatory agencies want to identify and eliminate compensation plans that “create risks that are reasonably likely to have a material adverse effect on the company.”

Matthews, Young – Management Consulting has worked with several clients assisting them with the necessary process and review of Compensation Policy and Plans, including a number of community banks participating in the TARP program who must comply with similar regulatory requirements.  Randy McGraw, a Senior Consultant with our Firm, collaborated with me to layout the specifics of Compensation Plan Risk reviews.

Scope and Timing of our Review

Our assessment of compensation programs requires a review of all compensation plans and practices (with emphasis on incentive compensation) to ensure that they do not encourage participants:

  • To take unnecessary and excessive risks which threaten the value of the company.
  • To manipulate reported earnings to enhance compensation.
  • To focus attention exclusively on short-term results at the expense of longer term performance that adds value to the institution.
  • For organizations taking TARP funds from the Treasury, at least every six months, the Committee and Senior Risk Officer (SRO) review all employee compensation plans related to excessive risk, manipulation of earnings, and short-term over long-term results.  The Committee is required to limit and/or eliminate any plan features that encourage such behavior.
  • For TARP recipients, SEC reporting companies, and all financial institutions, at least once every fiscal year, the Committee and SRO, in addition to review, discuss results and prepare a narrative description of findings and actions taken on any adverse findings in review.
  • For TARP recipients, within the first 120 days of the end of the fiscal year, the Committee prepares a narrative report describing Committee meetings, discussions, and actions.  The report must be submitted to both U.S. Treasury and primary regulator  For SEC reporting companies, results of review are reported in the proxy statement.

Key Elements of our Analysis

We will look at an overview of total compensation to ensure that:

  • There is a balanced mix of pay elements (base salary, annual cash incentives, long-term equity award incentives)
  • Base salaries are sufficiently competitive to avoid undue emphasis on earning incentives in order to earn reasonable cash compensation.
  • Potential incentive levels achieved from short-term and long-term plans are balanced to ensure sufficient focus on long-term results.

For short term incentive compensation, our review will be focused to ensure:

  • Reasonable number of participants.
  • Maximum incentives are capped and potential incentives are reasonable.
  • Performance measures require a balance between earnings, return, revenue or asset growth, operating efficiency, and asset quality or other risks.
  • Performance measures support achievement of operating as well as strategic goals.
  • Performance measures strengthen teamwork as well as match a participant’s areas of accountability.
  • Incentives do not create a conflict of interest for officers with compliance and audit responsibility.
  • Whether plans contain a claw-back provision which has been communicated to participants.

For long term incentive compensation (as applicable), our review will be focused to ensure:

  • Reasonable number and category of participants.
  • Stock overhang and run rate are in line with prevailing market practice.
  • There is balance between appreciation-oriented (options) and full-value (restricted stock) grants; as well as balance in full-value grants between time-vested and performance-based grants.
  • Option grant exercise price is at or above fair market value; and re-pricing is prohibited.
  • Vesting and performance periods are sufficient to emphasize multi-year service and performance.

Review Methodology

Bank regulations require that the Compensation Committee meet with the Bank’s designated Senior Risk Officer (SRO) to discuss relevant issues; and suggest using an outside compensation advisor to facilitate the compensation review.  This approach is also recommended for other types of organizations.  Our recommended methodology is as follows:

  • Matthews, Young – Management Consulting will assess compensation plans and practices based on information provided by client.
  • Matthews, Young – Management Consulting will draft a letter that describes our review and findings along with any recommendations for change and provide this letter to the SRO.  With client’s input, we prepare a table summarizing key terms of all incentive compensation plans specifically Plan Name, Plan Purpose, Participant List, Administrative Responsibility, Performance Measures and Incentive Payout Potentials.
  • SRO reviews our letter; assesses the potential risk created by compensation in the following risk areas: Credit, Market, Liquidity, Operational, Legal, Compliance, and Reputation.
  • SRO then prepares their own letter to the Committee summarizing the review process and findings.
  • Compensation Committee meets with outside consultant and SRO, reviews both letter and reports, identifies any actions required to modify plans, and documents meeting activities.

We are currently offering a free telephone consultation to further discuss the regulatory requirements and risk review process.  Please contact us if you would like to discuss your compensation plans and an assessment of the risks they may pose to your company.  Call 919-644-6962 and ask for David Jones, Randy McGraw or Tim O’Rourke.  You can also complete the request form at http://matthewsyoung.com/risk_review_contact_landing.htm.

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