Advice On Using Compensation To Link Revenue And Costs

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Costs related to compensation and benefits account for almost half of all non-interest expenses at credit unions, and have been increasing at a rate of 7% or more annually.

The key to staying on top of the situation lies in growing revenue, managing costs, and linking the two via an effective incentive program, according to one analyst.

Michael Higgins Jr., partner in Kansas City, Mo.-based business consultancy Mike Higgins and Associates, told board members at the CUES Directors Conference here that linking part of employees' compensation to both overall credit union and individual performance helps a CU's bottom line by encouraging a sales culture.

"Compensation and benefits expense represents about 50% of total non-interest expense. This percentage does not vary much by asset size," he said.

The problem for credit unions lies in the fact all other operating expenses grow by about 3% to 5% per year, but compensation and benefits expenses increase by 7% to 10% annually, explained Higgins. If revenue doesn't keep pace with the expense, the balance sheet takes a hit.

Both banks and CUs are seeing similar increases in compensation and benefits costs, because they are competing for the same talent. Higgins did not have figures for all industries.

Higgins said the problem cannot be solved by reducing compensation expense. Instead, he encouraged CUs to address the issue by growing revenue, suggesting that the "compensation efficiency ratio," or compensation expense divided by net interest plus non-interest income, is the "ultimate measure of productivity." This ratio represents the expense required to produce each revenue dollar, similar to a mutual fund's management fee.

To increase revenue, CUs must get employees involved through a weighted, performance-based compensation plan, he continued. The primary objective of rewarding performance is to maximize member satisfaction, but it also must improve achievement throughout the entire credit union.

"Otherwise, we aren't going to fix the convergence problem," he said.

A sound reward plan would include keeping total compensation competitive with other financial institutions through a combination of base and performance-rewarded salary. Frontline staff should be encouraged to sell, and they should be given a non-subjective series of measures.

An additional benefit, he said, is a performance-based compensation plan eliminates entitlements.

"I've seen many bonus plans that pay out 3% to 5% no matter what-good year or bad - because that's the way they've done it for 137 years."

If a CU focuses on the factors that are most important to its success, communicates to employees where it is going, gives frequent feedback on performance and rewards results, it creates a "win-win" situation, he said.

Hurdles

Higgins' recommended plan includes hurdles of performance for all categories, from loans to shares to member satisfaction ratings. He said these steps should be set above an established baseline. He labeled the hurdles, in increasing order of productivity: "realistic," "optimistic," "change of behavior," "out of the box," and "home run."

CUs should reward performance in each category precisely according to the effect on the bottom line, he said. If an increase in loans improves operating income by 25%, contribute 25% to the reward pool.

"People want to know, 'If I beat budget on something, how much will I get paid?' They need to have well-defined increments, and the size of the hurdle dictates the compensation. If all they do is hit the minimum, then there is no reward. But, don't make the hurdles too far apart-make them achievable."

Higgins described the plan's reward pool as "self-funding," because as the CU benefits more, the employees benefit more. The reward is created from a surplus. In one sample balance sheet, growth in balances and loans pushes a CU's operating income up by $2.5 million. He said the resulting reward pool to employees of $1.1 million is justified, and members still share in the surplus.

"A portion of the reward pool is predicated on the overall performance of the credit union. Another portion is connected to the specific performance of the individual. This is a balance of team and individual."

Directors' Checklist

Higgins encouraged the audience of directors to get to know not only their own CU's compensation efficiency ratio, but also how their ratio compares to their peers.

"If it is below the level of your peers, demand improvement," he said. "If it is at peer level, maintain or improve it. If it is better, then don't get greedy with a highly productive team."

When large retailers release their quarterly income reports, they frequently cite "same store" performance. Higgins said CU boards similarly should reward improvement in existing branches, while setting a timeline for the "new store" ramp-up period.

Most importantly, he said directors must know where their CU's total compensation stands versus the market.

"If a credit union does not pay rewards or incentives, then base pay must be above-market to make up for the lack of a variable-pay program," Higgins observed.

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