How CECL Will Impact Incentive Compensation Plan Design

It is widely accepted that the FASB’s Current Expected Credit Losses (CECL) accounting standard poses one of the most significant accounting changes for financial institutions in recent history. With the January 1, 2020 adoption date, many organizations have completed the “build” phase and have focused on the “parallel run” phase and determining the potential impact on earnings and capital. However, due to the challenges and complexities of getting to this step, many organizations are just now able to identify the broader implications CECL has on organization-wide operations, and more specifically, executive compensation.

While the new standard is expected to improve financial reporting by requiring timelier recording of expected credit losses on loans and other financial instruments, it poses some significant challenges as well. First, the process for identifying reserve levels will now be based on expected losses as opposed to incurred losses. This requires the ability to “foresee the future” and make predictions regarding the state of the economy, something that is difficult for experts to do well. Second, larger allowances may be required for most products, which may require changing the structure of the products themselves. Finally, as allowances increase, the pricing of products may change to reflect higher capital costs.

When taking all of these issues into consideration, it is obvious that there will be a significant impact on financial statements and profitability metrics related to how organizations choose to manage capital. This, in turn, has the potential to impact executive compensation and includes questions that revolve around the following topics:

1.  Will there be an adverse impact on profitability?
2.  Which profit and return measures will be impacted?
3.  Are these measures included as performance metrics in our organization’s short-term or long-term incentive plans?
4.  Will the inability to meet these performance metrics have a negative impact on our pay-for-performance culture?

The purpose of most incentive compensation plans is to motivate and incentive the “right” behaviors while still complying with regulatory guidelines. In the era of CECL, the issue may become how best to minimize (or explain) CECL’s impact on financial profitability metrics, while still demonstrating a direct link between the organization’s goals, the outcomes achieved, and payouts awarded to members of the executive leadership team.

 

Incentive Compensation

Incentive compensation plan design is typically rooted in the compensation strategy which describes how the organization will position pay relative to the external labor market. There are two types of incentive compensation:

1.  Annual (short-term) incentives that are based on the achievement of goals that span a 12-month period
2.  Long-term incentives that span a three- to five- year time horizon

While CECL compliance is more problematic for long-term incentive plans (LTIP) due to the likelihood that the plans were developed prior to the analysis of potential CECL methodologies and the forecasting of outcomes, it still impacts both plan types particularly when taking into consideration the increased volatility in profit and return measures.

Surveys indicate that formal, performance-based incentive compensation plans have been increasing in prevalence over the past few years. These plans typically include three to five performance metrics based on strategic, financial and/or quality goals weighted according to importance as defined in the strategic plan. Award payout levels typically vary based on different performance scenarios (threshold, target, maximum, etc.) and are determined at the beginning of the plan period. The most common performance metrics in the banking and financial services industries are illustrated in the adjacent charts from a 2019 BDO survey of 600 middle market publicly traded companies. 

It is very likely that CECL will impact the majority of these metrics. As one can imagine, any impact on profit and return measures will likely affect plan participants’ total direct compensation^[1] awards with the CEO and CFO positions expected to feel the greatest impact. Another potential area of impact is the organization’s budget, as a reduction in the size of the budget would reduce the amount of money available to fund the award pool. However, perhaps the biggest challenge isn’t monetary at all, but lies in the motivational disconnect in plan design and participants’ ability to achieve stated performance levels.


 

Remedies

So, what are the remedies for organizations facing these challenges? The first step is to review plan designs and determine which performance metrics are affected.  The second step is to review the CECL implementation timeline and determine if mid-year adjustments should be considered.  Note, however, that this is sometimes viewed negatively by shareholders and regulators, especially if payouts are made despite missing stated performance targets. Third, consider the use of relative metrics for publicly traded organizations that have goals tied to peer group rankings for both quality of earnings and risk management. Fourth, consider including modifiers in the plan document that allow the Board to make adjustments to payouts/awards due to extraordinary circumstances (i.e. CECL compliance and accuracy of forecasting methodology). Finally, postpone modifications to current plan design, but offer a retention bonus, or “special incentive” to offset losses that are outside the plan participants’ span of control.

It may take a number of years to fully understand the impact of CECL regulations and to see the impact of these regulations as tangible changes to the variety and type of performance metrics utilized.  However, there are many proactive steps that can be taken now to lessen CECL’s impact on executive compensation and incentive plan awards. BDO encourages the development of a solid communication strategy directed at internal plan participants, as well as an external communication strategy in the form of narrative descriptions of CECL methodology in the annual report and proxy statements. This narrative should include details regarding modifications to performance metrics and award payouts that are contrasted with anticipated performance scenarios prior to the adoption of CECL. Finally, it is safe to say that we will all look forward to a time in the not too distant future where we can base performance metrics and opportunity award levels for incentive compensation on carefully refined financial models.
 

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[1] Total Direct Compensation (TDC) – The sum of base salary + bonuses/annual incentives + the value of long-term incentive awards