Safety in Num6er5

What Credit Union Boards Need to Know About Managing Executive Compensation Risk.

According to a recent USA Today article, Martha Stewart receives over $29,000 annually for a personal trainer and $55,725 for a weekend driver. Ken Chenault, CEO of American Express, receives personal use of the corporate

jet (valued at $200,000) and a $139,000 local travel allowance. Randall Stephenson, CEO of AT&T, receives payment for life insurance premiums of $164,189 and home security valued at $30,504.

In the rarified world of Fortune 500 companies, executive compensation and benefits have been, and continue to be, “through the roof.” Credit unions cannot afford such luxuries. In fact, there is close regulatory scrutiny of what kinds of compensation and benefits credit unions can provide their executives. As a result, boards need to be very careful in how they design such plans — making them attractive enough to recruit and retain good talent, but not so “attractive” that they run afoul of the IRS and/or the NCUA.

“Years ago, benefits were called fringe benefits,” notes Paul Dorf, Ph.D., managing director of Compensation Resources, Inc., a compensation consulting firm in Upper Saddle River, N.J. “Clearly, their cost is not a fringe anymore. It is major undertaking.” Dorf cites data from the U.S. Chamber of Commerce, noting that 42

percent of compensation costs are comprised of benefits (taking all employee groups into account). Executives might get club memberships, vehicles, or SERPs (Supplemental Executive Retirement Plans), making benefits an even larger share of their compensation package.

According to Dorf, while health benefits are usually the largest component of compensation costs for employees in general, the SERP is usually the largest piece for executives. At one large credit union, he relates, the SERP totaled in the millions of dollars.

Rich Brock, principal with Burns- Fazzi, Brock & Associates, a Charlotte, N.C., firm that specializes in compensation consulting for credit unions, also sees growing pressure for expanded compensation and benefits. “More and more executive benefit plans are being put in place,” he states. “It is a recognition of the talent that credit unions currently have and the desire of boards to retain these executives.”

However, he cautions, it is incumbent on boards to make sure that the plans they put in place are indeed safe and that they understand the risks associated with these plans and all of the ramifications, including exit strategies and taxes.

The WesCorp Fallout

Jim Patterson is a partner with Sherman & Patterson, a Maple Plain, Minn., law firm specializing in employment benefits compliance, and he also sees more scrutiny of executive compensation and benefit plans. “We are clearly in a period where we are having greater regulation,” he states. “The WesCorp case sent shock waves throughout the director community.” As a result, the NCUA and other regulators are working to set new limits on executive pay at large institutions that will bar compensation that encourages risky business practices.

“The NCUA complaint argued that the board members were not diligent in analyzing and approving amendments to the SERP for the executives employed by WesCorp,” explains Patterson. “The board members had been told that the changes were administrative in nature. However, the changes actually increased the SERP benefits for three participants by over $4 million.” According to Patterson, this shows that boards need to be actively involved in compensation issues, seek third-party review, document their intent and have executive sessions (to make sure that, if someone has an interest in the plan, they are not part of the board discussion).

NCUA Rule 701.4

Another concern for boards is NCUA Section 701.4. “With this rule, it is very clear that the NCUA is raising the bar for federal credit union directors,” points out Patterson. The rule — which NAFCU has written about extensively — clarifies director duties and also sets out new financial literacy requirements for directors. For example, directors need to understand financial statements, including balance sheets and income statements, and why line items are changing.

Patterson believes the impetus for these changes stems from the WesCorp situation. “NCUA felt as though the WesCorp directors didn’t have the background information that they needed in order to make their decisions,” explains Patterson. According to Rule 701.4, directors who were already serving on credit union boards when the rule came out in January 2011 have six months (until July 2011) to receive the training — if they don’t already have it.

Rule 701.4 also clarifies that the board directly sets compensation for executives. “The NCUA also indicated that it doesn’t want CEOs to screen or filter information that they provide to boards,” continues Patterson. “There has been a concern that the boards weren’t getting all of the information that they needed.” In some cases, employees of the credit union, or consultants, may need to report directly to the board, to make sure that this filtering or screening doesn’t occur.

In essence, the buck stops at the boardroom. According to the new rule, the board must “directly exercise its authority to hire, fire, determine duties, set compensation and discipline senior management.” In addition, “the board must also ensure that appropriate policies are in place to guide senior management in the execution of their duties.”

NCUA Section 701.19

Patterson also points to NCUA Section 701.19, which provides a broad exemption to the rule that otherwise applies to investments for credit unions. “Section 701.19 is commonly used to justify benefit plans that are set up for executives,” he states. “Board members should still consider things such as liquidity of the investment, surrender charges, bond ratings of the providers and so on. In other words, boards should be good consumers as they look to establish benefit plans.”

Other considerations

Dorf sees an additional area of general concern, above and beyond those suggested by NCUA rules. While reviewing any credit union’s variable compensation plans, it is important to consider the inclusion of both “clawback” and “circuit breaker” provisions.

Clawbacks were first introduced in the Sarbanes-Oxley Act and have subsequently been included in the new Dodd- Frank Wall Street Reform and Consumer Protection Act. “These allow an organization to demand repayment of awards that time has shown should not have been paid out,” he states. Circuit breakers are specific financial thresholds and basic operating requirements that must be met before any awards are paid in the first place.

A final consideration: Patterson recommends considering the “multiplier effect” in compensation changes. “For example, if a board approves a salary increase for an executive, that same salary increase may also increase one of the non-qualified benefits provided to the executive,” he states.

Best practice recommendations

In light of the changing landscape, Patterson, Dorf and Brock have some best practice recommendations: “The starting point for establishing any executive compensation arrangement is for the board to prepare and adopt a compensation philosophy,” states Dorf. This is a written document that articulates a number of key aspects of the credit union’s pay program, including the relevant peer group, level of compensation within that peer group, the elements of the compensation package (fixed, variable and benefits) and other key aspects of pay strategy such as “pay for performance.”

Patterson adds, “Boards should establish a written compensation philosophy.  Even smaller credit unions that may not seem to need one should still have one.  It should set out the principles and objectives of their compensation philosophy, as well as what they are going to do from an administrative standpoint to monitor the compensation and make sure that the amount of compensation is consistent with their philosophy.”

Compensation decisions should be made by an independent body or subcommittee of the board, according to Dorf.

“Appropriate studies of peer organizations should be made by qualified independent counsel, and must be relied upon in determining executive compensation arrangements,” says Dorf.

All aspects of the compensation determination and specific arrangements must be in writing and fully documented, Dorf says.

“Have a finger on the pulse of what is going on in other financial organizations, such as banks, related to executive compensation and benefits,” suggests Patterson.

Consider hiring a consultant. “In the WesCorp situation, the NCUA felt that the board either didn’t understand what was happening at times, or didn’t consult with individuals who could have helped them understand,” notes Patterson.

Finally, be proactive, not just reactive.  Just because a rule or regulation does not apply to your credit union is no reason not to at least take it into consideration.

Example: “One of the more recent proposed NCUA regulations deals with incentive compensation,” explains Brock. “It says that no plan that is put in place by a board should be structured in a way that it encourages an executive team to take undue risk as a way to maximize their incentive plan. If they do, there are penalties involved.”

This proposed NCUA rule, Patterson says, is required by Dodd-Frank.  It focuses on excessive compensation and also excessive risk-taking, and whether either or both of these are occurring within a particular benefit plan design. “Many credit unions will not need to worry about this because it only applies to credit unions with assets in excess of $1 billion,” he continues. “However, if I were a board member at a credit union with less than $1 billion in assets, I would still want to look at this rule and try to determine what the regulators are heading toward because, at some point, it may apply to their credit union.”