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Auditing Incentive Compensation Plans – Risks and Conflicts

Auditing Incentive Compensation Plans – Risks and Conflicts. FIRMA 21 st Annual Training Conference Monday, April 16, 2007 Donald F. Moore, Jr., CEO Bearmoor, LLC (719) 748-6025 dmoore@bearmoor.com. Objectives and Goals. Overview of Industry Performance

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Auditing Incentive Compensation Plans – Risks and Conflicts

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  1. Auditing Incentive Compensation Plans – Risks and Conflicts FIRMA 21st Annual Training Conference Monday, April 16, 2007 Donald F. Moore, Jr., CEO Bearmoor, LLC (719) 748-6025 dmoore@bearmoor.com

  2. Objectives and Goals • Overview of Industry Performance • Discuss Incentive Compensation Arrangements • Outline Risks and Concerns of Incentive Compensation Plans • Provide Insight into Best Practices • Provide Audit Guidelines for Incentive Compensation Plans

  3. Auditing Compensation Plans • Why is there a need to audit compensation plans beyond base salary? • Revenue and Profits – Margins and returns are why we are in the business (i.e. shareholder value) • Fairness – Incentive compensation becoming a larger percentage of total compensation (Attract and retain talent) • Consistency – Deployed and implemented as intended • Applicability – Effective to meet business strategy and goals • Confidence and Trust – Among employees, clients, and the general public • Litigation Mitigation – Sales Personnel

  4. Types of Non-Base Salary • The Bonus • Position or Grade Dependent • Performance Dependent (i.e. sales quota or revenue goal) • Discretionary • The Commission – Revenue for Selling • The Stock Option – Incentive to achieve and maintain INCENTIVE COMPENSATION

  5. Concerns and Risks • Effective Compensation Plans • Department of Labor – Fairness Issues • DOL OFCCP Audit • Appropriate Compensation Plans • Corporate Strategy – You get what you incent, or do you? • Is there a process for reviewing the results with the desired outcome? Y or N • Incentive Compensation Plans – Major Goals • Motivate Employees • Make Payroll a Variable Cost • Is there a connection between individual performance and company results? Y or N • Are these expected results effectively communicated? Y or N

  6. Concerns and Risks • Fraud and Breach of Employment Contract • Confusion, Damage, and Litigation • Loss of Key Performers – Sales Personnel, Relationship Managers, Administrators, etc. • Is management aware of Incentive Compensation issues as they relate to the loss of key personnel? Y or N • Centrally Managed, Controlled, and Communicated • Altering Compensation Plan Mid-stream • Undermines Employee Trust • If changes are made, are they communicated to all effective personnel? Y or N • Changes in Senior Management • Is the Incentive Compensation Plan reviewed and approved? Y or N

  7. Incentive Compensation Results • Does Incentive Compensation produce measurable results? • Has the industry obtained the desired results? • What other factors can be attributed to the results?

  8. An Example • CEO Nardeli – Home Depot • Compensation Package up $210 million • Stock price during tenure – down 28% • CEO Skinner – McDonald’s • Compensation Package up $8.8 million • Stock price during tenure – up 36%

  9. Incentive Compensation Results 10 Year Growth Rate: 53.64%

  10. Incentive Compensation Results 10 Year Growth Rate: 30.19%

  11. Incentive Compensation Results 10 Year Growth Rate: 157.32%

  12. Incentive Compensation Results 10 Year Average: 25.89% 5 Year Average: 29.21%

  13. Decline of 27% Incentive Compensation Results

  14. Decline of 43% Incentive Compensation Results

  15. Incentive Compensation Results Custody 51% Non-Managed Fiduciary 6% Managed Fiduciary 39%

  16. Incentive Compensation Results 140% Custody 40% Non-Managed Fiduciary 75% Managed Fiduciary

  17. Market Performance

  18. Competition - Follow the Money

  19. Competition - Follow the Money

  20. Competition - Follow the Money 15. Seattle 23. Portland • Minneapolis 10. Detroit 7. Boston 21. Pittsburgh 1. New York 20. Sacramento 4. Chicago 22. Cleveland 6. Philadelphia 5. San Francisco/Bay Area 3. Washington 19. Denver 24. Cincinnati 25. Kansas City 18. St. Louis 2. Los Angeles 16. Phoenix 17. San Diego 12. Atlanta 9. Dallas/Ft. Worth 11. Houston 13. Tampa 8. Miami

  21. Incentive Compensation Programs • Sales Culture / Environment • Affected Personnel – not just for Sales Professionals • Portfolio Managers; Private Bankers; Administrators • Focus on New Business • From New Accounts (Sourced/Hunted) • From Existing Accounts (Referred/Harvested) • Focus on Revenue • Variable Compensation Plans with Base • 100% Variable Compensation Plans • Revenue Sources • Recurring Revenue (Annual Fees with a Fee Schedule) • Private Banking Revenue (Loans and Deposits) • One-Time Fee Revenue (Various)

  22. Recurring Revenue • Assets that produce annual recurring revenue: • Custody • Investment Advisory • Investment Management • Directed Trusteeships • Trusteeships • Incentive Compensation Based upon actual revenue produced – predominately %-based • Market Value fees • Non-Market Value fees

  23. Recurring Revenue • New Business that is Self-Sourced (Hunted) • New Account Assets or Additions to Existing Account • Highest Incentive Compensation % • Payout graduated over a period of years – with a fixed percent after a certain number of years.

  24. Recurring Revenue • New Business that is Referred (Harvested) • New Account Assets or Additions to Existing Account • Incentive Compensation is decreased from the highest amount based upon the compensation paid to the referring employee. • Payout graduated over a period of years – with a fixed percent after a certain number of years.

  25. Recurring Revenue

  26. Recurring Revenue • Does the Plan outline the employees that are eligible for recurring revenue incentive compensation? Y or N • Does the Plan define recurring revenue and how it will be determined? Y or N • Does the Plan outline whether or not market value increases or decreases caused by economic conditions will be considered in determining the payment of incentive compensation? Y or N

  27. Recurring Revenue • Does the Plan consider a reduction in recurring revenue incentive compensation if non-standard fees, or fee discounts are applied? Y or N • Does the Plan provide for a “splitting” of recurring revenue incentive compensation among eligible employees? Y or N • Does the Plan outline the what documentation and system fields required to be completed before recurring revenue incentive compensation is paid? Y or N

  28. Private Banking Business • Incentive Payments for Banking Business • Deposits • Loans and Credit Facilities

  29. Private Banking Business • Does the Plan provide for incentive compensation for the generation of Private Banking Business? Y or N • Does the Plan provide incentive compensation on the net interest income for a deposit account? Y or N • If incentive compensation is paid, for what time period? • If incentive compensation is paid, are additional deposits to the account included, or must they be of a certain $ amount? Y or N • Does the Plan provide for incentive compensation on the net interest charged and the fees generated on new loans, and for how long? Y or N

  30. Private Banking Business • Does the Plan provide incentive compensation on the renewal of loans and/or mortgages? Y or N • Is there a time frame for determining the dollar amount of the incentive compensation? Y or N • Does the Plan outline that incentive compensation for Private Banking products be paid at funding or in arrears? • If the payment is made at funding, does the Plan provide for a “clawback” provision? Y or N

  31. One Time Fee Business • How is One Time Fee Business Defined? • Financial Planning • Tax Planning • Long Term Tax Planning Programs • Qualified Intermediary • Capital Markets • Special Fiduciary Arrangements • Will Appointments • Life Insurance Trusts (Unfunded)

  32. One Time Fee Business • Does the Plan provide for the payment of incentive compensation for One Time Fee Business Opportunities? Y or N • Does the Plan outline the incentive amount to be paid for One Time Fee Business Opportunities? Y or N • Does the Plan outline the calculation to be used to compute the incentive for One Time Fee Business Opportunities? Y or N • Does the Plan detail when the incentive for One Time Fee Business Opportunities will be paid? Y or N • Does the Plan provide for a “clawback” provision for One Time Fee Business Opportunities? Y or N

  33. One Time Fee Business Three things can happen when you throw a pass, and two of them ain’t good. Woody Hayes, OSU Football Coach Perhaps we should apply this same philosophy to a couple of One Time Fee Business examples.

  34. One Time Fee Business • Will Appointments • Incentives paid at the time a Will Appointment is obtained create unique risks. • Set Dollar Amount ($) • Percent of Net Worth (%) • Substantiation of Net Worth • Responsible Party • Documentation • Asset Breakdown • Marketable • Non-Marketable

  35. One Time Fee Business • Will Appointments • Is the incentive compensation paid on Will Appointments based upon a set dollar amount or a percentage of the Current Net Worth? • If compensation is a set value, is the value a fixed dollar amount for all Will Appointments or is it graduated based upon the Current Net Worth? • If compensation is based upon a percentage of the Current Net Worth, how is the value established? • Who is responsible for establishing the value of the Current Net and have controls been developed to ensure that the process is being followed? • Is the Current Net Worth certified by a non-interested party? • Have “clawback” provisions been established?

  36. One Time Fee Business • Life Insurance Trusts • Incentive compensation paid for the Appointment as Trustee in a Life Insurance Trust have complex issues. • Set Dollar Amount ($) • Percent of Value (%) • Based on Size of the Life Insurance Policy • Face Amount • Cash Value Amount • Potential Secondary Market Amount • Graduated or Fixed

  37. One Time Fee Business • Life Insurance Trusts • Is the incentive compensation paid on the appointment of a Life Insurance Trust based upon a set dollar amount or a percentage of the policy value? • If compensation is a set value, is the value a fixed dollar amount for all Life Insurance Trusts or is it graduated based upon established criteria (i.e. face amount; cash value, or other)? • If compensation is based upon a percentage of the policy value, how is the value established? • Who is responsible for establishing the value of the Life Insurance Policy and have controls been developed to ensure that the process is being followed? • Is the established value of the Life Insurance Policy certified by a non-interested party? • Have “clawback” provisions been established?

  38. Structure • Plan Administration - Centralized • Development • Plan Terms and Conditions • Definitions • Incentive Compensation Sharing/Splitting • Eligibility and Exclusions • Forms and Supporting Documentation • Communication • Written • Acknowledged • Final Determination – binding and conclusive • Authority to make all determinations • Review and resolve all disputes • Interpret and apply terms and conditions • Responsible for reviews and updates

  39. Structure • Plan Deployment • Prospects • Current Clients • Referral Sources • Owner • System Identification

  40. Structure • Some important language to incorporate into the Plan. This Plan shall not be deemed to constitute a contract between the (bank name) and any eligible employee or to be a consideration or inducement for the employment of any eligible employee. Nothing contained in this Plan shall be deemed to give any eligible employee the right to be retained in the service of (bank name) or interfere with the right of (bank name) to discharge any eligible employee at any time. The Plan is subject to review, suspension, amendment and/or termination at any time with or without notice by (bank name).

  41. Incentive Compensation Audit • Objectives • Ascertain if the incentive compensation is paid in accordance with the established Plan. • Determine whether incentive compensation is accurately calculated. • Assess the use of incentive compensation benchmarks and reporting processes. • Ensure the level of total incentive compensation is commensurate with intended results and the level of risk established.

  42. Incentive Compensation Audit • Information Request • Previous audits, reviews, or self-assessments • Current Incentive Compensation Plan – description and requirements • Incentive Compensation documentation and related forms and material • Organizational chart of the Sales function • Policies and procedures for recording and documenting prospects and sales • Training material outlining the incentive compensation program • Sales goals and supporting documentation

  43. Incentive Compensation Audit • Necessary Activity • Interview key personnel specific to the Incentive Compensation Process • Review Incentive Compensation Plan and relevant documents, including policies and procedures. • Perform testing to determine accuracy and consistency between the Plan, the system, and supporting documentation. • Review internal controls, specifically regarding the separation of duties. • Summarize findings and report findings.

  44. Incentive Compensation Audit • Items to Consider • What is the frequency incentive compensation is paid? (monthly, quarterly, etc.) and does it differ for external referral sources? • What department is responsible for processing the payment of incentive compensation? • Do reports exist to track trend data (i.e. product, department, employee, region, as a percent of revenue, etc.) – Examples:

  45. Incentive Compensation Audit Do the trends make sense? Are variances explainable? Do the trends correlate with increasing accounts, assets or revenue? Does management track trends? Do the trends coincide with the types of business desired?

  46. Incentive Compensation Audit • Best Practices Review • Does the Incentive Compensation Plan provide for a stable base with incentive payments linked to performance? • Individual Performance • Team Performance • Division Performance • Does the Incentive Compensation Plan support the strategic goals of the organization? • Types of Business • Types of Clients • Revenue Goals

  47. Incentive Compensation Audit • Best Practices Review • Is the Incentive Compensation Plan competitive and equitable? • Industry Compensation Surveys / Study • Attraction and Retention • Revised and Updated • Does a process exist for accurate and effective communication of changes/revisions to the Incentive Compensation Plan? • Input from Sales Personnel • Documentation on Receipt of Information • Training Material

  48. Incentive Compensation Audit • Best Practices Review • Does the Incentive Compensation Plan outline goals for key management position? • New Revenue Goals • New Account Goals (types and size) • Profitable Account Retention Goals • Does the Incentive Compensation Plan provide for the creation and development of performance metrics? • Incentive Calculations and Payments Cycle Time • Measurement against Total Revenue, New Revenue, Net Revenue • Measurement against Account and Asset Growth

  49. Incentive Compensation Audit • Audit Work Program • Observe and Document the Incentive Compensation Program • Gather Evidence to Support Incentive Compensation Paid • Completed Forms and Documents • Booked Sales • Recurring Revenue • Private Banking Revenue • One-Time Revenue • Review Application of Incentive Compensation Rates • Fixed Payments • Variable Payments • Application of Effective Rates and Percentages • Review Payment of Incentives Paid • Receipt of Revenue • Booking of Business

  50. Incentive Compensation Audit • Audit Work Program • Observe and Document the Incentive Compensation Program (continued) • Review Incentive Compensation Consistency • All eligible personnel • Splitting / Sharing • Client or Relationship Transfers • Review Overall Plan Administration • Segregation of Duties • Approval Process • Application of Discounts • Review of Retention and “clawback” Provisions • Review Referral Source Payment, if applicable

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