Discretion in Incentive Plans: Taboo or a Must?

Discretion is often considered taboo in the executive compensation world. Compensation committees that use discretion in determining incentive payouts risk receiving criticism from investors and proxy advisory firms, whose policies tend to prefer formulaic incentive plans. However, discretion is an important feature of many banks’ annual incentive plans that, if used appropriately, can enhance the pay and performance relationship.

There are two common annual incentive plan models used by banks: purely discretionary incentive plans and formulaic incentive plans.

At banks with purely discretionary incentive plans, the compensation committee determines annual incentives by conducting an assessment of company performance, considering both quantitative and qualitative criteria. There is no predefined formula, which gives the compensation committee flexibility to use a holistic approach and consider various factors to determine the payout. This approach mitigates the risk of overly focusing on any one performance metric to the detriment of overall performance and long-term success.

At banks with a formulaic incentive plan, the compensation committee determines annual cash incentives based on performance relative to predefined financial and nonfinancial goals that are set at the beginning of the year. While some banks rely solely on a formula, these plans often incorporate discretion in one or more of the following ways:

• Weighted component: A portion of the bonus (such as 15% to 25%) is based on a review of quantitative and qualitative criteria.
• Modifier: Annual incentive funding can be adjusted up or down (for example, up or down by 15% to 25%) based on a review of quantitative and qualitative criteria. Some banks also apply a modifier to individual payouts based on each executive’s accomplishments relative to individual performance objectives.
• Adjustments to financial metric or overall funding: The compensation committee determines a reasonable adjustment to the financial metric or final payout to address the impact of unplanned events.

How Discretion Can Be Positive
A modest amount of discretion is a positive feature of a bank’s annual incentive plan. Discretion allows compensation committees to reward not only for what results were achieved but also how those results were achieved – including considerations like risk outcomes and regulatory compliance – and allows committees to adjust for factors that are outside of management’s control.
The compensation committee should define the performance criteria and articulate it to participants at the beginning of the year to inform a comprehensive evaluation of company and/or individual performance at the end of the year. One way for banks to implement this structured approach to discretion is to use a scorecard that allows the compensation committee to assess performance across multiple categories. A sample scorecard is outlined below:

Potential Challenges of Applying Discretion
It is important that pay outcomes reflect company performance and are aligned with the shareholder experience. The two most influential proxy advisory firms, Institutional Shareholder Services and Glass Lewis, prefer formulaic incentive plans for public banks and could criticize the use of discretion if they perceive a pay and performance misalignment. Banks can mitigate concerns by discussing the compensation decision-making process, demonstrating rationale for discretion and showing how pay and performance are aligned in proxy disclosure.

Incentive plans that are fully discretionary or that have significant discretionary components also put pressure on compensation committees to “get it right” at year-end. Establishing performance criteria at the beginning of the year and using a structured process with robust discussion to evaluate performance can help give the committee, executives and shareholders comfort with the outcomes.

Lastly, it is important to be consistent in applying discretion, adjusting for both unanticipated headwinds and tailwinds to avoid the perception that discretion means increased payouts in down years.

A formulaic incentive plan as the primary determinant of payouts continues to be the right approach for many banks. However, every bank should consider if there is a role for discretion in their plans to optimize alignment between pay and performance. Discretion provides the compensation committee with the flexibility to make decisions that reflect the overall performance of the bank while considering the impact of external factors on performance results and strategic accomplishments that may not lend themselves to formulaic assessments. In all cases where banks use discretion, it is important to have a robust and structured decision-making process to ensure transparency, fairness and consistency for both executives and shareholders.