After a catastrophic year in the financial services industry, four of the Big Five banks have released management information circulars detailing substantial reductions in the total direct compensation of their CEOs. However, most of the CEOs have received more options, which could boost their compensation down the road.

Bank CEOs voluntarily forgoing mid- and long-term compensation have made headlines recently. But, says Stephen Griggs, executive director of the Canadian Coalition for Good Governance in Toronto: “The headlines do not necessarily reflect reality.”

That’s because substantial parts of the pay packages that were not relinquished are options and other units that will not vest for four years — and their worth will depend on the banks’ share prices at that time.

The goal in executive compensation is to align executive pay and bank performance, especially long-term performance. As such, a substantial part of the bank CEOs’ pay packages — ranging from 85% to 90% of total direct compensation — is dependant on performance. Effectively, the only pay executives are guaranteed is their salaries.

Although each bank has its own benchmarks and metrics for measuring performance, growth in earnings per share, return on equity and total shareholder return are key measures of overall performance for all the banks — and none of the Big Five cleared their respective hurdles in the fiscal year ended Oct. 31, 2008.

As a result, these depressed metrics are being reflected in executives’ pay packages. Royal Bank of Canada awarded its president and CEO, Gord Nixon, $8.7 million in salary, bonuses and mid- and long-term incentives in 2008, vs $10.9 million for 2007.

Rick Waugh, president and CEO of Bank of Nova Scotia, was awarded a package valued at $7.5 million for 2008, compared with $9.4 million for the year prior. Reduced short-term incentives such as cash bonuses represent the biggest cuts for both Nixon and Waugh.

Canadian Imperial Bank of Commerce president and CEO Gerry McCaughey, based on the idiosyncrasies of his contract, is paid for the bank’s performance a year after the fact. So, he was paid in December 2008 for the bank’s performance in fiscal 2007.

Without taking into account the events of 2008, McCaughey’s total direct compensation would have been almost $13 million; however, after further metrics were applied to the 2007 results, the number was smaller and, eventually, the board and McCaughey agreed that he would forgo certain short-term incentives and take home a package valued at $5.3 million, composed of salary, stock options and performance units.

Band of Montreal president and CEO Bill Downe passed up more than $3 million in mid- and long-term incentives — options and other units based partially on stock appreciation — and took home only his $1 million in salary and a short-term bonus of $1.4 million for 2008, vs $5.5 million in total direct compensation for 2007.

Toronto-Dominion Bank is the only one of the Big Five that has yet to release its information circular; it gets mailed by Feb. 16.

With the exception of Downe, the other three bank CEOs received the bulk of their compensation in stock options and synthetic equities. The purpose of the grants is to link the executives’ fortunes to the long-term performance of their companies. (Which is why it is baffling that BMO’s board of directors would allow Downe to forgo a long-term component to his package.)

Although Downe passed up options, Waugh and Nixon received more options this past year than in the prior year.

While the dollar value of the three CEOs’ total compensation packages have taken a substantial hit, the named executive officers are receiving more stock options or notional units tethered to the price of common shares and company performance than they have in recent history.

Why? This past year, in a curious turn of events, bank share prices shrank by much more than bonuses did. So, even though mid- and long-term incentive program grants are smaller than in previous years, they convert into options on more shares — and at the lowest exercise prices for five years. Normally, the challenge of executive compensation is linking the executives’ pay to the downside risk of the bank. Right now, by issuing lots of options, boards of directors are linking compensation to the upside risk.

@page_break@Case in point: at the end of 2007, when CIBC’s share price was high, McCaughey received $750,000 as part of his long-term incentive plan, consisting of 70,045 options on CIBC common shares at an exercise price of $79.55; a year later, in December 2008, he was granted $742,500 for fiscal 2008, which translates into 92,528 options at an exercise price of $49.75. (McCaughey was also granted a further 106,481 options as part of his 2007 package at the exercise price of $49.75.)

Options grants made this year will translate into significant rewards for the bank CEOs down the road because of the lower exercise prices — presuming share prices recover some of the value in the next decade that they lost in the past 18 months. But if share prices do not improve, more than this year’s options are at stake. “Last year’s options are worthless right now,” says Robin Cornwell, founder of Catalyst Equity Research in Toronto.

In fact, every option issued in the past five years is out-of-the-money, as current share prices are lower than exercise prices.

Further, the valuation of previous years’ pay packages is meaningless if long-term incentive plans are worthless. As a result, everything depends on how the banks fare in the next few years.

“Banks know how to deal with loan losses,” Cornwell says. If the market has taken this into account in valuing bank stocks, he sees a 25%-30% recovery in their share prices, which would result in a lot of options being in-the-money. IE