May/Jun 2010

Three experts tell credit unions how the financial crisis should and shouldn't change executive pay.

In hindsight, it’s not surprising that executive compensation played such a central role in the financial crisis of 2008. Excessive-risk taking, poor judgment and bad management –– these are all characteristics that defined the worst executive compensation practices leading up to the crisis.

While credit unions wisely steered clear of compensation packages that could be deemed excessive, the crisis revealed that even credit unions were not immune from making ill-informed decisions about these plans. In several cases, such decisions led to surprising losses of revenue for the credit union in question, undermining not just CEO earnings, but potential dividends to member-owners.

In light of these experiences, credit union board members are understandably more cautious than ever about decisions relating to their executive compensation plans. For this article, TFCU spoke with three experts in the field to examine what practical steps board members can take to design an attractive, yet safe, CEO rewards package in a post-financial-crisis world.

A lack of understanding

Among the most devastating effects of the financial crisis was the blow dealt to the stock market, which sent the value of equities and commodities plummeting. By early November 2008, the S&P 500, a broad U.S. stock index, was down 45 percent from its 2007 high. For the many companies that were funding benefit plans via equity-based investments, this was particularly traumatic.

Rich Brock, principal of Burns-Fazzi, Brock, a NAFCU Services Preferred Partner, points out that the equity market had been remarkably consistent in the years leading up to the crisis, typically providing an annual rate of return at roughly 9 percent. It’s not surprising then that so many people were caught off guard by what happened, he says.

Unfortunately, credit unions were among those that got burned. One particularly onerous scenario that Brock saw more than once: A credit union taking a huge hit because its executive compensation plan was designed in such a way that it left the institution exposed to serious risk. Millions of dollars in retirement benefits were consequently wiped out in a flash.

Brock recalls one executive compensation consultant who had been successful for years by “basically just taking credit union money and saying, ‘We’ll take $5 million and invest it in the market; whatever it grows to, the executive team can have.’ But then you get to September 2008, and $5 million suddenly became $3 million. And then the executive team says, ‘Uh-oh, we didn’t sign up for this.’ They’re now in a situation where it’s going to take seven years to get back to where they were.”

For the credit union board members that approved such plans, it was a case where the risk was not properly understood. Brock points out that executive compensation plans are much different than compensation plans for regular employees. The former tend to be multi-faceted in their design, with a lot of complex, moving parts. “Benefit formulas could be based on any number of factors, such as interest rate assumptions or equity performance,” Brock notes. “If you don’t understand what could possibly go wrong, it can result in a pretty big mistake.”

Unfortunately, more mistakes were made following the events of September 2008. Alec Berkman, president and CEO of Executive Compensation Solutions, notes that the stock market situation prompted some credit unions to sacrifice their strategic compensation goals “in favor of some fairly panicky, tactical changes in operation.” The end result, he says, is that “people were doing things precipitously without advice, cutting back benefit plans without understanding what they were doing. It was hard to watch.”

Imagine a credit union, Berkman says, that makes an across-the-board cut in its 401K funding without taking into account that it has been using a portion of those funds –– say $15,000 –– to help offset a $100,000 a year supplemental retirement package for the CEO. “That just makes them pay for the executive benefit with other dollars when the executive retires, and the unintended consequence will be that all of the employees had their retirement benefits cut back … except for the executive.”

Philosophy and execution

These strategic shortcomings all point to what these experts say must lie at the heart of every executive compensation plan: a well-defined compensation
philosophy.

What exactly does that mean?

Put simply, an executive compensation philosophy is the crystallization of the board members’ views relating to executive pay. Brock points out that these philosophies are “as diverse as the backgrounds of the board members themselves.” For example, a board made up of individuals who have worked for the public school system may feel a lot differently about incentives than a board made up of individuals with more of a corporate background, he says. “You really get a wide variance.”

Findings from NAFCU’s 2009 Executive Compensation and Benefits Survey, conducted by Burns-Fazzi, Brock, bear this out. While base pay continues to account for the lion’s share of credit unions’ executive compensation, the survey found some variances: Some credit unions rely more on incentives and less on the base in structuring the total compensation package. The survey also found many differences in the way credit unions structure their incentives. “It really depends on what the philosophy of the particular credit union is,” Brock says.

Not only does an executive compensation philosophy reflect the board’s outlook on base pay and incentives, Brock says it helps answer some tough, and frequently technical, questions, such as: “Is the base pay at an appropriate level? Is the incentive compensation in the form of a bonus? Should a non-qualified plan be offered, and if so, how would it fit into the overall strategy? That’s really what your biggest concerns would be.”

John Andrews, executive vice president, compensation for D. Hilton Associates, points out that it’s not enough to have an executive compensation philosophy; a credit union must also have a plan on how to implement that philosophy. “What are the best practices or commonalities of the stronger credit unions? They document their executive compensation plan, execute it with consistency and have good continuity when it passes from one committee to the next,” he says.

Unfortunately, many credit unions struggle with consistency, including ones with a clearly understood philosophy on executive pay. “Consistency is the number one challenge,” Andrews says. “If you commit to a philosophy, you can’t just implement a plan based on that once and then wait five years before revisiting it.”

Brock agrees, noting that BFB urges its clients to review their executive comp plans at least once a year. “We want to make sure that boards understand year by year why they put in place the plan they did, how it is performing, and whether or not it is in line with their credit union’s peer group. Especially if you have new board members coming along –– they might turn around one day and ask, ‘Why did we put this thing in?’”

According to Andrews, a credit union’s failure to carry out a plan with consistency ultimately sends a mixed message to the CEO. “If you publicly commit to saying, ‘This is what we want to do,’ and then don’t do it every year, a CEO will find that challenging,” he says. “It is ultimately a form of feedback on performance whether they think it is or not.”

Simplicity is key to safety
Safety and soundness is a phrase Brock uses a lot when discussing executive compensation with clients these days, and he notes that boards have made a concerted effort to simplify their plans to reduce risk.

“Most of the changes that I’ve seen are really tweaks to the benefit formulas,” he says. “Boards are reducing the number of moving parts in the benefit formula so it’s easier to calculate.”

Understanding how these moving parts are interrelated is key to safeguarding a credit union against risk. Brock says that all the various components of an executive compensation package –– the base pay, the incentives and the retirement benefits –– should never be perceived as “islands in and of themselves” but rather as part of a whole. 

Though Brock points out that BFB does not get involved with conversations about whether a specific benefit is appropriate or not, the company makes sure its clients understand what the potential for risk is. “You don’t want a surprise in the last year of a CEO’s tenure,” Brock says. “And we’ve seen them. Gosh, I could tell you horror stories.”

If there is significant risk associated with a particular benefit, BFB will suggest ways of modifying the comp plan, Brock says. BFB structures executive comp plans in such a way that “there is very little financial risk, if any. A lot of times there’s none.” How is that possible? “Well, the funding or the investments that the credit union can make will either have guarantees or you can closely match the expenses of the plan with the income,” he explains.

Berkman agrees that volatility does not have to be a prerequisite for an executive comp package. “Why would you buy a variable market-based annuity to fund your investments and subject yourself to the volatility? Let’s use that same kind of tool, but let’s get a baseline guarantee,” he says.

Performance, not entitlement
All three experts agree that high-performing credit unions with good executive comp plans tend to emphasize performance rather than entitlement.

“High-performing credit unions pay for what they’re asking for as opposed to paying for arbitrary things,” says Andrews. “To cite the old example, if a credit union just became a community charter and its strategic goal is to gain market share in its community … move away from an affinity group to more of a diverse membership within a community, that’s what they should pay for.”

Andrews points out that 50 credit unions in a single peer group could easily have 50 different metrics for determining how the CEO is paid. “There’s not a golden metric that determines how credit unions should pay their executive,” he says.

Regardless of how the executive is paid, the compensation should be used to drive progress and growth, Berkman maintains. “Boards should be linking the executive compensation to performance goals that are strategic to the credit union and consistent with its longer-term strategic plan,” he says.

Of utmost importance is for the CEO to have a clear understanding of how he or she is being compensated. If the credit union board feels strongly that entitlements should not represent a large part of the compensation package, it must communicate this to the executive in question.

“The bottom line,” Berkman says, “is that board members need to be asking themselves, ‘Do we want to look backwards at what’s been accomplished and make a decision that may or may not be in alignment with what the CEO expects? Or do we set up an understandable, well-communicated compensation methodology and evaluation system going forward?’” If it’s the latter, Berkman says, the CEO should never be in the dark about how he or she will be rewarded beyond the base compensation.

Determining an executives’ base pay can be tricky for a volunteer board, according to Berkman, who notes that the volunteers are, for the most part, coming out of different industries and may find evaluating the CEO’s pay challenging. “You can’t measure the CEO’s comp against the city manager,” he says. “It’s difficult for some board members to get over that hurdle. We have to talk about it very frankly. You have to explain to them, ‘You cannot compare your CEO to your boss.’ That’s just not how it works … and that difference in viewpoint has to be overcome.”

Think before you cut
Once a credit union is clear on why and how it wants to reward its executives, the idea of reducing existing compensation numbers may well be raised. “The caution is that you have to stay within a competitive range or you’re going to lose your people,” says Berkman. “I think it would be difficult to advise a credit union that it could cut compensation and move forward. It might be a good short-term move to show a singular financial result or to hit a number that the regulators might be looking at. But in the long-term, I think my philosophy would be to pay my people at some average number in terms of base and drive performance with measures that are linked to either bonus or long-term rewards.”

Andrews says he understands why credit unions find such cuts attractive. “It’s a natural inclination to think about freezing compensation to deal with budget issues,” he says. “So you save 3 percent on your budget. ‘Everybody’s going to share the pain’ kind of thing. But if I don’t have the right folks to turn things around, it could be a short-sighted decision.”

According to Berkman, it’s important to think of the quality of what compensation buys, not just the quantity of the spend. “It is the most important investment a credit union can make because they’re making it in their most important asset, which is their people. You don’t deliver anything to your members except through your people.”

Ultimately, the biggest determining factor in the quality of a credit union’s executive compensation plan is the degree to which the board is informed about the subject. It would be difficult to overstate the importance of understanding how these plans work, including what the potential for risk is. The good news: Armed with this knowledge, board members can better position their credit unions to attract the top talent their members so richly deserve.

Rick Taylor is NAFCU’s senior writer.