The Wells Fargo incentive pay problem is at least as old as Matthews, Young; and we’ve been advising the banking industry on performance-based incentive compensation for over 40 years. Decades ago when we discussed design of incentive plans, we would half-joke about avoiding the creation of an employee mindset of “open an account and get a new toaster; open three new accounts and get three toasters”.
Our experience tells us that a cardinal rule of incentives is that you get what you pay for – in terms of employee behavior and results. If your bank sets new account goals without incorporating a balancing measure like branch customer satisfaction, you are sending a problematic message: account growth matters and gets rewarded and customer satisfaction does not. If your incentives are driven by Net Income growth without corresponding Return on Assets / Equity measures, you are telling management that it’s okay to inflate the balance sheet for that extra dollar of profits. If loan growth is the key to incentive earnings without corresponding credit quality requirements . . . well, we all know where that got us in the recent past!
Business news reports of the Wells Fargo problem indicate that another cardinal rule of incentives may have been violated: employees must have a reasonable chance of achieving goals and not fear losing their jobs for failing to achieve what they perceive as unobtainable results. Such a situation will cause some employees to quit trying and others to start their search for different employment. Or in the Wells Fargo case, employees will find a way to achieve goals even when they know their behavior is inconsistent with customer interests and, ultimately, shareholder return.
We also believe that Wells Fargo’s decision to cancel incentive plans is an over-reaction. Well-designed incentive plans are an effective management tool to:
- focus attention and action plans on key results
- motivate individual effort and teamwork
- link company and employee success
The Wells Fargo story will fade in the press, but we believe it should be a wakeup call for banks to take a fresh look at incentive plans. With the new year approaching, now is the time to ask the tough questions: Are performance measures balanced with respect to growth, profitability, soundness, and customer satisfaction? Are expectations reasonably obtainable and do employees have the proper tools and training to perform at their best? Are payout levels competitive but reasonable compared to base pay (e.g., are high incentives necessary for cash compensation to be competitive)? Are we supporting our incentives plans with effective employee communications that explain expectations for results and behavior?
Matthews, Young has been advising banks, thrifts, and credit unions for over four decades on the use of sound incentive compensation. We are experienced in the design of new plans as well as the review of existing plans. Contact us at: Info@MatthewsYoung.com.
There is a clear trend among companies to strengthen the linkage between shareholder and executive interests. Many companies are responding to this trend by evaluating the effectiveness of having stock ownership and/or stock retention guidelines for their executive officers.
We observe that implementing such guidelines in the current economic environment can be challenging for these executives. Since executive cash compensation is flat or increasing only slightly, achieving stock ownership requirements can represent a greater burden than in the past.
However, these difficult times also present a partial solution. Many companies decided not to give salary increases to key executives for 2009 and, some cases, 2010 as well. Hopefully, those companies are having better financial results this year, are concerned that executive salaries may trail the market, and are considering giving an additional salary increase beginning in 2011 – say five percent on top of whatever a regular raise might be. Herein lies the opportunity to address some of the challenge of increasing executive stock ownership.
Instead of granting the additional raise, consider an equivalent value in Restricted Stock Units (RSU’s) with a reasonably short restriction period (e.g., two years). Since the salary increase is an annuity as long as the executive is employed, then the company would grant the same dollar value in RSU’s every year. RSU’s also offer an interesting feature that is not available with Restricted Stock grants – RSU’s can be voluntarily deferred beyond the restriction period as long as the executive complies with IRS Code Section 409A requirements related to the deferral.
This approach offers several benefits both to the company and to the recipient:
- The executive defers income taxes until actual shares are finally received at the end of the restriction period, including the voluntary deferral period. Thus, the executive accrues more shares than if the additional salary were used, on an after-tax basis, to buy stock.
- The company’s stock ownership guidelines would give credit for RSU’s that have been granted and not yet converted into actual shares. By using the voluntary deferral procedure, the executive can count all RSU’s towards meeting stock ownership guidelines as well as postpone income tax.
- There is also the option to take cash in lieu of shares (or a portion in cash to pay income tax and the remainder in shares) at the end of the deferral period, or to defer the cash payout as long as the executive complies with IRS Code Section 409A rules.
- The company does not have to issue actual shares until the end of the voluntary deferral period.
- Since this will be an ongoing program of annual grants and increasing stock ownership among executives, there is also a pretty nice story to tell shareholders.
These are challenging times for addressing executive compensation issues. But maybe this is one of those instances of being handed “lots of lemons”, but using the opportunity to “make some lemonade”.
To be clear, I am not talking about discretionary bonus pay. That is money wasted by managers who do not know what to expect of their business or their employees. I am talking about a promise to pay a specific amount for a specific outcome, and the promise is made in advance of the performance period. You know, the kind of incentive you used with your kids, or your parents used with you. “Son, please give up the girl, sell the motorcycle, go back to school…..” Sometimes an incentive can be a stick, but often a carrot is more effective.
When the economy and the effects of the bursting of the latest bubble are threatening your company, management teams need focus, and properly designed incentives create focus. It’s not that good people need to be bribed. Rather, when an incentive is properly designed it communicates a powerful message of what is expected from employees. It focuses the team on exactly what you need. Let’s face it, there is little less effective than a talented group of people all pulling in opposing directions. When times get tough, the tough get going….but you better make sure they are going in the right direction.
One bank CEO told me recently, “I need the Incentive Plan now more than ever,” as he strategized how to reduce loan losses, raise capital and improve liquidity. This team has a new set of metrics based on that strategy and a significant upside opportunity if they achieve the turnaround. The shareholders and management team will win or lose together and there is no question what it will be worth.
It is true that incentive pay, if large enough to create the focus that is needed, can be dangerous. You will get what you pay for, so you better make sure you want it. I have seen companies driven over cliffs with poorly designed incentives. In financial services, care must be taken to incent asset quality, risk management, controlled liquidity and interest sensitivity risk…..not just growth.
As the economy stumbles along through a slow recovery, unusual opportunities will become available. Will your team be ready and focused?