The recent downtrend in earnings and share prices at major banks has only heightened institutions' awareness that they need to attract and retain top talent to compete successfully.
A major challenge facing bank management today is developing cutting- edge compensation and benefit packages and ensuring that these packages get shareholder approval.
Stock, stock options, and stock purchase rights have been payment vehicles of choice. But due to recent shareholder concern over equity dilution, banks now are putting greater emphasis on nonqualified compensation-such as deferral programs-and life insurance to reward executives. These compensation options not only please top executives but also are being lauded by shareholders.
Deferred compensation plans are among the most popular nonqualified compensation alternatives. These plans defer part of an executive's compensation. Payment is usually made at the termination of employment or upon disability, retirement, or even death.
The plan usually provides for crediting of interest on the deferred income, typically at very attractive rates. This lets executives maximize tax-deferred growth and ration out their total earnings over an extended period.
Traditional deferred compensation programs have some drawbacks, such as limits on the amount of income that can be deferred. Today's deferred income plans, or DIPs, however, are more like 401(k) look-alikes.
DIPs are ideal because they overcome limits on the deferred amounts as well as timing restrictions on the payouts. Executives can choose to defer up to 100% of their salary and bonuses and write their own pre- and post- retirement options. As executives' needs change so too can the amount of deferrals and payout arrangements.
Banks and their shareholders also benefit from DIPs. If funded properly, these programs can give banks a significant tax advantage.
This advantage will be visible on the bottom line early on and over the long term.
While nonqualified plans can be designed to mirror qualified plans, they are not perfect substitutes for their qualified counterparts.
They lack many built-in protections available with qualified plans, such as protection of assets by the Pension Benefit Guarantee Corp. and asset segregation from the corporation.
Furthermore, with benefit promises typically extending for 20 or more years and the nonqualified portion of many executives' retirement benefits frequently exceeding 50%, there are concerns about whether executives will receive promised benefits.
Bank management is challenged to supply maximum security for executives while minimizing the potential adverse financial impact of any nonqualified benefit plan. That means banks must find ways to securitize those benefits, though also seeking ways to increase earnings per share using creative financing tools. These issues face banks and nonfinancial companies alike; however, the challenge to banks may be greater as a result of regulatory guidelines limiting how banks invest.
A number of funding mechanisms exist, such as secular trusts, rabbi trusts, and various life insurance investments that offer varying degrees of security and investment return to banks and their executives.
Secular trusts (also known as employee-grantor trusts) offer security to participants by fully vesting contributions immediately. Participants are protected from unforeseen events that otherwise might have threatened their assets since the assets in the trust are not accessible to corporate management or creditors' claims in case of bank insolvency.
However, there is a cost for this security. The Internal Revenue Service defines these assets as taxable personal income because the individual is guaranteed the income at some future date. In addition if the trust is not properly designed, income on the assets may be taxed to the corporation as well as the individual.
As a result, a rabbi trust often is a more attractive option.
Properly designed trusts provide security without causing constructive receipt of income by the executive of either the contribution or the trust earnings. Rabbi trusts typically are funded through a variety of investments, including equity funds, bonds (high-grade corporate or treasury), tax-free bonds (municipals), or bank-owned life insurance.
One of the most attractive financing options is bank-owned life insurance. Since corporations generally have an insurable interest in the key executives whose untimely deaths could have a negative impact on the company, banks often buy life insurance on select employees to recover benefit and compensation costs. Specially designed life insurance policies will let companies get the maximum benefit from each source of return, such as the accumulation of cash value in the policy and tax-free death benefits.
Split-dollar life insurance is another form of insurance frequently used to finance nonqualified programs. The name refers to splitting the death and living benefits of an insurance contract's cash value between two parties. The policy accrues cash value between inception and retirement. In addition these plans offer a great deal of financial flexibility, such as lump-sum or annuitized payments.
Though the design of executive compensation plans differs from bank to bank, a common thread links all banks.
Compensating key executives is an integral part of a bank's strategic planning. Faced with the sometimes conflicting objectives of the government, shareholders, and executives, banks must offer competitive benefit programs.