The Advisors' Blog

– Mike Kesner, Deloitte Consulting

Financial services companies (among others) should consider taking proactive steps to go well beyond the minimal (and ineffective) TARP requirements to reform their executive compensation practices, including:

1. Re-set the pay mix: Financial services executives earn a very high proportion of their pay (cash compensation and restricted stock) based on short-term results. This is virtually unheard of in every other industry, where the lion’s share of compensation (60% – 75%) is based on long-term, equity based incentives. Companies need to adopt long-term incentive arrangements tied to the Company’s long-term business plan that reward sustainable, long-term improvements in financial and stock price results. Performance shares tied to earnings growth and relative total shareholder return are likely to be used far more extensively than in the past.

2. Roll-back pay levels: Pay levels at some financial institutions routinely exceeded $30 million, and were justified based on pay for performance. Boards would be well-advised to reduce pay levels to more sensible levels. A good place to start would be by targeting the median, and allowing performance to drive above or below median pay. Another important step would be to cap incentives at 200% to 300% of target levels. While these reductions could lead to the loss of some executive talent to hedge funds, private equity, and start-up investment firms, this step is essential to restoring investor and taxpayer confidence.

3. Adopt “hold backs” and “hold to retirement” policies: An important method for keeping executives focused on sustained, long-term performance is to adopt “hold back” and “hold to retirement” policies. A “hold back” provision generally applies to the annual incentive, where a portion of the earned incentive is held back for at least one year (and sometimes longer), and subjected to future performance conditions.

Thus, if one year’s financial performance funds a maximum payout, a portion of the incentive is held back and paid only if the subsequent year’s financial targets are achieved. Holdbacks may vary depending on participant’s level in the organization or size of the award, and a 25% to 40% holdback is common. “Hold to retirement” provisions require that executives retain [50%] of the after tax value of earned equity incentives. This requirement is in addition to the regular stock ownership requirements. Hold until retirement provisions help to ensure the amount of wealth the executive ultimately accumulates is, in part, tied to the Company’s total shareholder return during their career with the Company.

4. Eliminate perquisites, gross-ups and other “executive entitlements”: In order to promote internal equity and fairness, many companies treat all employees the same when it comes to benefits and some impose a higher cost burden on those that can best afford it. [Citicorp was one of the first companies to charge executives for the full amount of their healthcare benefits.]

While it is difficult to quantify the level of resentment and lost productivity resulting from the perceived injustice created when executives keep lavish perquisites and benefits while employees endure higher healthcare premiums, suspended 401(k) contributions and layoffs, it is likely substantial. Shareholder ire is also caused by tax gross-ups, with the harshest criticism leveled at tax gross-ups on executive perquisites.

5. Modify severance arrangements: In addition to modifying severance benefits to comply with TARP, consider:

– Broadening the definition of termination for cause to include poor performance.

– Eliminating excise tax gross-ups.

– Capping the severance multiple to 1x base salary and target bonus for non-change-in-control terminations and 2x for a change in control related termination.

– Adding appropriate restrictive covenants (non-solicitation/noncompete).

– Adopting double trigger vesting provisions in a change-in-control (i.e., must have a CIC and lose your job).

– Linking severance protection with financial need. Thus, if an executive has accumulated significant wealth during their employment with the Company, no severance will be paid. Alternatively, phase-out severance protection within 5 years of hire or promotion to executive officer.