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Closing the Gap

December 2010 – Vol: 33 No. 12
by Karen Bankston

Boards seek safe, fair avenues to fund supplemental retirement benefits for top executives.


With the growing shared sense that we may finally be putting the worst behind us, credit union boards are pondering how to structure long-term compensation with the goals of rewarding and retaining top executives and recruiting talented successors, while simultaneously complying with regulatory standards for the safe and reasonable informal funding of supplemental retirement benefits.

As reported in the September issue of Credit Union Management, CUs are closer than ever to parity with comparably sized community banks in annual salary and bonuses for CEOs and other members of the executive team. However, a large gap remains in the area of long-term and deferred compensation.

Much of that gap owes to time and the diversity of informal funding options. While supplemental executive retirement programs and deferred compensation plans have been a fixture among community banks for decades, these benefits are relatively new in the credit union industry, dating back to about 2000, says Christine Burns-Fazzi, principal of Burns-Fazzi, Brock, a CUES Supplier member based in Charlotte, N.C.

“And when you look at data from banks for long-term compensation, what you see is that probably 80 percent of all community banks have some sort of stock option plan,” a funding mechanism not available to credit unions, Burns-Fazzi notes. “When you measure that compensation and other retention tools in the form of SERPs and deferred compensation, coupled with the value of stock options, that’s where the big differential is.”

An analysis comparing CEO compensation at three Midwestern banks and CUs (with total assets in the $900 million to $1.2 billion range as of 2008) by Burns-Fazzi, Brock demonstrates how this differential weighs in. The three CU CEOs earned total annual compensation ranging from $481,520 to $510,810, including annual bonuses ranging from $33,267 to $91,940. In comparison, public records for the three banks showed CEO compensation ranging from $470,605 to $658,198. Although the banks reported awarding no bonuses in 2008, their CEOs did receive equity or stock option awards ranging from $30,607 to $90,860. In addition, the highest paid executive in the sample was paid through a “non-equity incentive plan” an amount equal to the base annual salary—about $250,000. In fact, this bank CEO’s base pay represented only 38 percent of total compensation for the year.

Focus on Funding

Of course, stock-based bonuses lost some steam in the recent recession, and continued uncertainties in the financial markets have left their mark on compensation decisions across the financial services industry. Despite recent economic setbacks, Gene Zumwalt, director of executive benefits intelligence for CUES Supplier member CUNA Mutual Group, Madison, Wis., says many credit union boards continue to commit to funding supplemental retirement benefits for their CEOs and other top executives.

There are two parts to the decision to fund supplemental retirement benefits for the executive team, alone or in some combination, Zumwalt says. The board must first select a permitted plan; popular options include 457(b) and 457(f) plans and split-dollar life insurance policies.

457 plans fund retirement benefits for highly paid employees of tax-exempt organizations. Under 457(b) plans, execs can defer taxes on a set amount of income each year, up to $16,500 in 2010 and 2011. Under 457(f) plans, credit unions can accumulate assets they continue to hold until they are turned over to the executive as taxable income at agreed-upon points, such as retirement or leaving a position due to disability.

The credit union and executive can also split premiums and proceeds under split-dollar life insurance policies as a way to fund long-term compensation plans.

To finance these plans, the board must also agree on funding products. In this area, many organizations are maintaining or moving to life insurance products from highly rated companies that offer guarantees and relatively good rates of return in comparison to current interest rates.

Among credit unions that do not offer supplemental retirement plans for their CEOs, some boards may be reasoning that there is not enough time to create a substantive benefit for a long-time executive nearing retirement and that other financial constraints are just too pressing right now. But those boards must be prepared to revisit that decision in hiring a successor because their top candidates will likely expect those kinds of benefits as part of their standard compensation package, says Joe Tripalin, director of marketing, OM Financial Group, Smithfield, R.I.

“What you’re finding is that in almost every case, when a new CEO is being hired, that candidate is asking the board for some type of supplemental retirement plan,” he notes. “It’s a much more common request. They understand that while the 401(k) is a nice plan, it just doesn’t allow them to set aside as much as they need for a comfortable retirement.”

Best Approach

Beyond the limited options available to credit unions to create long-term benefits for their executives in comparison to community banks, Zumwalt sees differing motivations as well. While the primary aim of credit union boards in approving 457 plans and life insurance programs is to close the retirement gap, the stock options offered to banking CEOs are fundamentally “wealth-building devices,” he suggests.

“I personally feel it’s very appropriate to focus on the retirement gap—and you certainly can’t have any other discussion until you get that one taken care of,” he adds. “We’ve also seen more credit unions focus on extending supplemental retirement benefits across the top management tier—again for retention and keeping the team together. There’s plenty of work to be done there.”

There is a significant gap between a reasonable retirement income and the nest egg highly paid executives can accumulate in 401(k) programs and the retirement benefits offered to all staff, Tripalin says. In fact, in most cases, those funds combined will replace less than 25 percent of a CEO’s final salary. The aim of supplemental retirement funding is to increase that ratio, typically to around 70 percent, to provide “a living wage in retirement.”

Another impetus for developing long-term executive compensation programs is that many credit unions are catching up to community banks in terms of size and capacity—and the need for talented, experienced leadership. That means credit unions are increasingly recruiting executives from the same talent pool as community banks, and the ranks of those executives are accustomed to long-term rewards in addition to annual salary and bonus. “When you look to recruit and retain that talent, credit unions have to be ready to step up to the plate and compete,” Burns-Fazzi suggests.

She cites the results of a recent survey from the National Association of Federal Credit Unions, Washington, D.C., reporting that 20 percent of the top executives at FCUs have a non-qualified retirement plan, and one in 10 CU boards are either reviewing their current plans or considering offering this benefit. The bigger the credit union, the more likely it is to maintain a supplemental retirement plan for its CEO and other executives.

First Things First

The first order of business is ensuring that existing plans will provide an adequate retirement benefit for executives nearing the ends of their careers. Especially when the return of the informal funding mechanism is tied to the stock market, plan performance in recent years has been disappointing at best.

Percentage of CUs Offering Various CEO Retirement Benefits
401(k) Plan
Defined Benefit Plan
Defined Contribution Plan 14%
Money Purchase Plan 7%
457(b) Plan 46%
457(f) Plan 32%
Other Retirement Plan 10%
Source: CUES Executive Compensation Survey (1/30/09-4/30/10)

“We’ve done a lot of repair work on those plans, especially where the principal or asset is under water or there’s a lot of risk or high charges associated with it,” Burns-Fazzi says. “Each case is unique. You have to work through where you are in the life of the product and how you can correct for the situation you’re in. If your CEO is close to retirement, you may need to deal with how you make sure the expected benefit is available in a short period of time. The expense may need to be condensed pretty tightly.”

Many SERPs that have been in place for a number of years have experienced sub-par performance, Tripalin says. “We’ve seen numerous situations recently where the CEO is retiring with no supplemental benefit. The credit union set up funding with a goal of recouping its original investment. Once it does that, there’s just no additional money there for the executive. They had hoped to be able to have a nice supplement, but because of the market returns, they’ve ended up with nothing.”

Over the past decade, the return on market-based funding vehicles has been zero on average, Tripalin says. Since simply adjusting their projections for returns on the same investments upward to make up for lost ground is unlikely to close the shortfall, many credit unions are looking for alternatives in the form of life insurance products.

“What’s really happened over the last four or five years is that the industry has moved more toward insurance-based funding programs. Our organization and many others are all using some sort of insurance-based funding mechanism, in part to get away from market fluctuations and to give the executive and credit union greater assurance that the program is going to perform as anticipated,” Tripalin says.

Eight or 10 years ago, when most CUs relied on mutual funds or other market-based securities to fund supplemental retirement programs, they might have projected a 7 percent return and considered that conservative, he notes. These days, though, “they’ve dialed their expectations back to maybe 5 percent, and you can get relatively the same type of return through a life insurance policy in dividends or an interest-based program.”

Keeping All Options Open

If the original retirement horizon is closing in, the board may talk with the CEO about staying on board for a while longer or about adding other options, such as “welfare benefit plans” which offer continuing coverage for the executive’s welfare, offering post-retirement medical and split-dollar life insurance, Burns-Fazzi notes. “But the key is to start talking about it now—the sooner, the better. The longer you put it off, the worse the situation gets.”

While some executives are considering delaying their 457(b) retirement plan payouts to continue to add to their retirement savings, “changing a retirement date can be very complex, and it may or may not be permissible depending on the structure and timing of the plan,” Zumwalt cautions. “The tax code regulations have gotten much more complicated than they used to be for supplemental retirement benefits.”

Even in the current low interest rate environment, CUs have access to funding vehicles for supplemental retirement programs that return at a higher rate than other investments, such as CU-owned life insurance arrangements or managed equity account programs, because regulations permit more flexibility in investing to pay for executive benefits than investing for other reasons, Zumwalt explains.

Proceed with Caution

Boardroom discussions about executive benefits are tempered with heightened concern—on the part of both regulators and CU directors—that it be “fair and reasonable” and reflect “safety and soundness.”

“We’ve done a lot of repair work on these plans, especially where the principal or asset is under water and there’s a lot of risk or high charges associated with it.” ~Christine Burns-Fazzi

“For a number of years, our theme has been board education and safety and soundness,” Burns-Fazzi says. “Boards are taking this very seriously, and regulators are paying more attention to it in the environment we’re in right now.”

The board must pay close attention to the design of the long-term compensation program and the CU’s obligations as spelled out in the legal documents that form the program. For example, what triggers payments under the plan, and how are those payments to be funded? Also: How does the informal funding mechanism react in the market and current economic environment?

Such standards are not new, but they have gained increasing attention from regulators in the wake of recent setbacks in the financial services industry. Burns-Fazzi recommends that board due diligence must encompass three crucial areas: knowing your vendor, understanding plan design and conducting annual reviews.

The recent upswing in the market has revived the performance of some plans, Tripalin notes, but many credit unions, especially those in regions hit hardest by the recession, continue to respond to financial challenges. “While it might be appropriate to put some kind of SERP in place, the board may not feel that this is the time to do it,” he says. “It’s a difficult time right now for credit unions, and many of them are delaying decisions on supplemental executive retirement plans for a period of time until some of these issues are sorted out.”

The bright spot in discussions in board rooms and conferences around the country, says Burns-Fazzi, is that executives and directors have greater certainty about the future. They know where they stand with NCUA oversight and assessments, and they are starting to talk about catching up once the salary freezes of the last couple years end.

“I’m not saying we’ve come out of this and there certainly are regional differences, but these kinds of considerations speak to people starting to feel a little bit better and looking to that light at the end of the economic tunnel,” she says. “They have an expectation about what’s going to happen over the next X number of years.” End of Article

Karen Bankston is a long-time contributor to Credit Union Management and writes about credit unions, membership growth, marketing, operations and technology. She is the proprietor of Precision Prose, Stoughton, Wis.

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