It took the loss of a few key employees to other businesses before Drew Donnelly realized that it was time to change the way he paid his staff.

Mr. Donnelly, chief executive officer of the State Bank of Wheaton, in Minnesota, decided the annual Christmas bonus just was not cutting it anymore. But how could he increase compensation when the bank's financials were not stellar?

"I was besieged by employees who were unhappy about the level of pay, yet performance wasn't improving," says Mr. Donnelly.

With the help of Coy Lewis, a Houston-based bank compensation consultant, Mr. Donnelly developed a program at his $55 million-asset bank that rewards employees from senior managers to entry-level clerks if the bank hits certain performance targets.

While virtually every major bank in American has found ways to tie pay to performance, the concept is still relatively untried in community banking circles. But that is changing.

With stockbrokers and other businesses tempting bank employees with promises of hefty bonuses and commissions, community banks have realized that competitive salaries are not enough to lure the best workers.

Though no data have been collected on the number of community banks that have adopted incentive compensation programs for rank-and-file employees, industry officials say, based on anecdotal evidence, that dozens of banks have done so. And the number is clearly growing.

"I feel like this is the route for community banks if we're going to maintain profitability into the next millennium," says Mr. Lewis, the consultant.

Chuck Cowell, chief executive officer of First Graham Bancorp., said he has seen changes in worker attitudes since his bank instituted Mr. Lewis' program a year ago. "They're taking care of the little things."

Mr. Lewis, a former community banker, said he started pitching the idea of pay for performance in the late 1980s.

At many community banks, the traditional form of pay is salary and possibly an annual bonus. Often, who gets how much depends on subjective measures, such as a manager's perception of an employee's performance that year, Mr. Lewis says.

Mr. Lewis, who is working with 60 banks, advocates a system that he says could double employee bonuses and bolster bank performance significantly.

According to Mr. Lewis, a state-of-the-art incentive-pay or variable-pay plan can reward top-notch employees with bonuses ranging from 14% to 25% of base salary, compared to 8% to 12% under a traditional system.

The notion of paying a 25% bonus makes many community bank CEOs cringe. But Mr. Lewis says they should think again.

"If you have a good incentive pay plan and high-performing employees, they'll earn that bonus and reward stockholders," he says.

But Mr. Lewis believes that only the most talented employees should truly benefit from an incentive plan. That is where a performance review system comes to bear.

"In order to have an absolute incentive pay plan, you must be able to define the goals for individuals and departments," he says.

"The people who would not be included are those who want to do the same job day after day, year after year, at the same performance level," he says.

Mr. Donnelly hired Mr. Lewis for $10,000 late last year to create a variable-pay program for his bank.

Mr. Lewis began by conducting a survey of 10 other Minnesota banks to determine whether Bank of Wheaton was paying people fairly. His verdict: the bank had to raise salaries immediately.

The consultant also helped Mr. Donnelly establish tangible goals. It was determined that the most important way to measure performance was to look at loan, asset, and earnings growth, as well as return on equity.

Certain variables that affect profitability are not included in judging performance. Large gains on investments, for example, are excluded.

Under the plan, 60% of profits in excess of the bank's target are returned to employees, while Mr. Donnelly - the sole shareholder - would get 40%, the executive said.

The financials will be calculated in mid-January 2000 to determine the level of payout, if there is one.

Once the plan was in place, Mr. Donnelly had to convince employees that linking pay to performance was a good thing. "At several meetings, I told them I want to pay more but we have to earn more," he says.

However, employees expressed concern at the prospect of losing their bonuses. That spurred Mr. Donnelly to make an offer that violated Mr. Lewis' approach: the executive promised that employees in the first year of the plan would not make less than they did the previous year.

"That calmed them down," Mr. Donnelly says. But he acknowledged that his act of generosity might cost the bank a bit in profitability during the program's first year.

William McNinch, chief executive officer of Community Bank and Trust, a $716 million-asset bank company in Beaumont, Tex., launched an incentive pay plan a year ago.

"The administration takes a while, but that's really the only negative," he says.

For employees at First National Bank in Graham, Tex., an incentive plan devised by Mr. Lewis two years ago has doubled the payout to many of the bank's 50 employees, says Mr. Cowell, the bank's chief executive officer.

Mr. Cowell says the incentive program, which is based on goals for return on equity and return on assets, has been just as fruitful for the $115 million-asset bank. First National Bank's ROA jumped from 1.34% in 1996 to 1.6% in 1998.

"It has been very beneficial," Mr. Cowell says. "We used to have a standard Christmas bonus. But it was something employees got used to, more of a given than an incentive."

So to do away with providing automatic gifts to employees, First National Bank put the following plan into action: whatever profits were earned above target would go to employees and shareholders.

For the first $100,000, 60% would go to employees and the remainder who go to shareholders. The second $100,000 would be divided evenly among the shareholders and employees.

Michael E. Grove, chief executive officer of Countricorp, the $38 million-asset holding company of First National Bank of the Rockies, White Sulphur Springs, Mont., says his employees care more about how the bank performs since it started a bankwide bonus program several years ago.

The bonus pool, based on return on assets, uses employees' base wages to determine what percentage of the pool an employee will receive.

"It gets all the employees more knowledgeable about what the bank does and how we do it," he said. "We talk about bank earnings and bank expense and they ask questions."

Mr. Donnelly's only regret is that he did not institute an incentive pay program years earlier at Bank of Wheaton.

"I've come to put so much more value on my staff than I used to," Mr. Donnelly says. "I began to ask myself, 'What happens if they leave?' I need them. They're good."

Ms. Falcone is a freelance writer in Baltimore.

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