Grilled peanut butter and banana sandwiches may sound like an odd combination, but they are fairly popular in the South and were one of Elvis Presley’s favorite foods. Presley loved the unique culinary combination so much that his personal chef was tasked with making them at all hours of the day, often with the addition of bacon. To this day the sandwich combination is synonymous with his name, frequently listed on menus as “The Elvis.” Modifications of the peanut butter and banana sandwich have emerged over the years and have even been incorporated into hamburgers and embraced by famous chefs such as Nigella Lawson. While questionable pairings can sometimes prove to be better than expected, regulators are a bit more skeptical about incentive plans being paired with businesses’ overall profitability and are taking a closer look at the practice.Aligning executive incentive plans with overall profitability is a popular approach among many businesses, as it is believed that doing so motivates employees to work harder at achieving key objectives to help an employer’s global performance. Within the banking industry, many financial institutions tie executive compensation to overall company performance, based on metrics including profitability, shareholder returns, and risk management. Lloyds Banking Group recently announced that its share incentive plan had acquired partnership and matching shares for multiple executives as part of an effort to align the interests of both the company’s leadership and shareholders.The Negative Impact of Incentive-Based CompensationTying someone’s compensation to company performance, however, can be a double-edged sword, as it can cause significant stress for employees who feel they must work harder or go to greater extremes to elicit visible results and can cause negative competition among colleagues. This can result in burnout for those feeling pressure to achieve more and can also cause a lack of confidence among those who aren’t seeing the same incentive returns as their colleagues. In the case of executives who stand to make considerable amounts of money, incentive-based compensation can also create the temptation for such individuals to take greater risks in hopes of larger payouts. Aware of this likelihood, regulators have been enhancing their oversight of the practice. This comes amid heightened media coverage of the mammoth payouts to CEOs and other executives at financial institutions including Bank of America, Capital One, JPMorgan Chase, and Wells Fargo, among others.Where Regulators StandThe Federal Deposit Insurance Corp. (FDIC), the Federal Housing Finance Agency (FHFA), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) are joining forces to address their concerns. The regulators have proposed alterations to the rules regarding incentive-based compensation at financial institutions with assets of $1B or more. The Federal Reserve Board and the Securities Exchange Commission did not participate in the proposed rule changes, noting the need for further study on the impact of the potential changes. However, both agencies have also voiced concerns about current regulations regarding incentive-based compensation. Understanding the Proposed ChangesThe proposed changes from the FDIC, FHFA, NCUA, and OCC piggyback off the Dodd-Frank Wall Street Reform and Consumer Protection Act. The pending guidelines elaborate on a proposal initially put forward in 2016 and are an effort by regulators to rein in risk-taking within financial institutions.Under the proposal, additional restrictions would be placed on financial institutions to prevent executives from subjecting organizations to unnecessary risks because of the potential for greater payouts for themselves. To do this, financial institutions would be required to ensure a few things:
- That incentive-based compensation plans are not excessive
- That they are proportionate to the services an employee provides
- That they do not encourage executives to assume risks that might result in financial losses for their institutions.
Factors used to determine the appropriateness of such compensation plans would include the following:
- Comparisons to executives’ past compensation and those of employees with comparable expertise and experience
- Compensation at comparable organizations
- The degree of governance and oversight
- Any ties between an employee and any fraud or wrongdoing within the organization where they are employed
The Potential Impact of Proposed ChangesIn addition to heightening the controls surrounding incentive-based compensation, the proposal would require financial institutions to maintain detailed records regarding executive compensation plans, including annual reviews of the actions of senior executives and any significant risk-takers — individuals among the five highest paid within an organization, anyone able to commit more than 0.5% of their employer’s capital, or anyone with 33% or more of incentive-based compensation. Regulators are also considering lowering the limit of options that can be awarded as part of incentive-based compensation for senior executives, as well as anyone deemed a significant risk-taker, from 15% to 10%.Beyond reining in the benefits that can be tied to compensation, the proposal would also introduce requirements for financial institutions to recover incentive-based pay under circumstances where organizations are harmed by any undue risks taken by executives. These situations range from misconduct that leads to reputational or financial harm for an employer to fraud, like the intentional fabrication of information that an executive’s compensation is based on. Organizations would have the ability to claw back both cash and equity incentives for seven years from the point that a financial award vests. Between heightened regulatory scrutiny surrounding incentive-based compensation tied to a company’s overall performance and unpredictable political and macroeconomic factors that could render performance-based compensation insufficient to retain key employees, community financial institutions may want to consider alternative compensation approaches. A few things to think about include establishing wider ranges of goals instead of fixed performance criteria, measuring employee performance against peer groups, and even granting separate retention awards to employees. While incentive-based compensation can drive performance, its risks and regulatory scrutiny highlight the need for balanced approaches. By exploring alternative strategies, financial institutions can better align employee motivation with sustainable growth and stability.
