Chief Investment Officer
incentive compensation trends
Incentive compensation plans are now par for the course in all walks of banking life. From the internal audit department to various sales forces, incentive compensation is a primary motivational and behavior guidance tool. The real problem is: it works…but often in unintended ways which do not align team member activities with shareholders’ interests and bottom line results. We most recently found that to be true with the CRE concentrations so many of us have experienced. When RMs were rewarded for volume only, they grew loans rapidly and collected their incentives, yet were not held accountable for policy and documentation exceptions, asset quality deterioration etc. At the same time, when incentives work as intended, bank and shareholders benefit greatly. Case in point: compensating commercial bankers largely for deposits.
Incentive programs are extremely effective in focusing staff’s attention and motivating the right behavior. Unfortunately, they also bring the most creative side of people. Some team members will inevitably figure out the easiest, most expedient way to maximize incentives, and often this is not the result originally intended by the program.
How to avoid this problem and yet comply with your next incentive compensation audit? Here are some thoughts:
- Make incentives meaningful. Incentive plans work because they make a difference in the financial environment of those who are eligible for them. Calibrate the amounts to the base annual salary of the team member to assure you don’t over- or under-pay. Make the amounts significant; in other words, 5 or 10% total bonus opportunity will not create sufficient excitement or motivation to meaningfully change the behavior of most of your people. Since you’re paying for performance, there is less downside for larger payments. If the program is structured right, the more you pay the more your shareholders make.
- Make it simple. Some programs are extremely complex, because they attempt to avoid the pitfalls mentioned above, or aim at very specific behaviors. Even if the formulae are clearly spelled out, there is a significant error rate in calculating incentives that are complicated. Any time you need to correct mistakes, it diminishes the effectiveness of the program. Complex programs make the opportunity for more mistakes. Simple is better.
- Focus on what really matters. Is it behavior? Is it a specific balance sheet item or product? Think through in your own mind what you’re trying to achieve first, then build a plan around it. The more factors that enter the plan, the less focus it will provide and the more confusion you’ll experience with the troops who are executing your plan.
- Don’t change your mind in the middle (unless you told them you will). Plans do not always work as planned… However, they are an important moral agreement between management and the team. If the team delivers and management is faced with overpayment, one is almost always better off paying and changing the plan at the next plan period. I always included a line in the plan saying “management reserves the right to change the plan monthly”. This way you have the flexibility to make continuous mid-course adjustments and fine-tune the program.
- Manage the leading indicators. Often, when final results are managed, they are reached in the wrong ways. The total deposit growth example is an instance where providing incentives for the final result was insufficient to channel the right behavior for the staff. Occasionally behavior is more important than the final result, as you bring about cultural change. In addition, achieving the right behaviors will get you the results you’re looking for. Therefore, incenting for results only may be insufficient. For example, including prospecting (number of calls, appointments etc.) in a commercial lending program nay not bring bottom line impact today, but it is very likely to do so tomorrow.
- Put the plan in context for the team. Explain the purpose behind it (we need more loans because deposits are growing faster; we need more relationships with our customers because we have too many single service businesses or households). People are more likely to do the right thing when they know what it is… They will also understand how the plan works better if they have the appropriate context for the various incentive components.
- Acknowledge mistakes. Incentive plans, much like everything else we do, are subject to continuous improvements. We all make mistakes, and that’s OK unless you bet the bank. Acknowledging that the program didn’t work as anticipated, and connecting the changes you’re making to that, are important steps in the communication process and in building acceptance to plan changes.
- Don’t change too often. Some people believe that frequent incentive changes are healthy and keep the troops on their toes. I feel it is important to build continuity of purpose and skill sharpening. This is especially true for behavior change and skill building. For example, if prospecting is a stated goal, you will need at least a couple of quarters to get your people executing effectively what you’re looking for. Similarly, if the sale of complex products is a component of your plan, shifting quickly to another product will not give your team sufficient time and opportunity to learn the sales techniques of the product and get real good at selling it. Last, frequent changes imply lack of strategic context and continuity. Your people may wonder if you know your mind and are committed to a specific strategic course. Consistency (but not stagnation) is important.
- Pay for production beyond minimum standards. Our salaried employees, even RMs, should produce a minimal level of output before they get incentives. In the brokerage world it’s called, “covering your desk”. In my world it’s called “fair”. Incentives are precisely that – designed to inspire employees to achieve beyond the basics.
- Consider holdbacks. Traditional incentives, especially in the commercial world, were paid fully and infrequently. 100% of the incentives due were paid out quarterly or annually. Paying more frequently but not all the incentives due might prove to be a more effective method to capture and retain employee attention, while accumulating a backlog of “incentives due” to become “golden handcuffs” in a few years. Further, holdbacks are a management tool to exact accountability by backing out incentives if asset quality, promised balances etc. don’t pan out as planned.
- Pay on actual results, not anticipated outcomes. For example, pay on actual average balances during the period, or on actual profitability of the business. This will help align shareholder and employee interest more closely.
- Automate. Manual inputs for the purposes of incentive calculations are cumbersome, prone to errors and suspect. Explore automation possibilities. If your plans are as simple as they should be, automation should also be possible.
- Caps or no caps? I’m not a fan of capping incentive plans. I believe that capping demotivates your best performers, who are the ones you’re trying to motivate the most. Are there better ways to ensure you don’t overpay or incent bad behavior? Yes there are… Review your incentive programs to ensure you’re paying precisely for the behavior and results you want, those that bring you most value. It sounds silly, but all too often we state that we want one thing (say, deposits), yet pay for something else (say, loans).
- Make sure you don’t pay too much. Sounds complicated? Work with your finance people to calculate the anticipated profitability of the “lift” you’ll get if incentives are to be paid, and take a portion of that amount (no more than 30%, to allow a wide margin for error) to be paid as incentives. This way the shareholders are ensured to get their fair share first.
- Don’t forget the risk mitigants. These are so important not only for the regulators who will examine your incentive plans to ensure they do not promote excessively risky behavior, but also for your own peace of mind and sound management.
Building effective incentive programs in today’s environment is essential to motivate all team members, line and staff alike. Making sure they achieve the intended results is the first step to success.