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.
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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