Securing Nonqualified Benefits in Today's Corporate Environment

Fact: A few years ago, the Wall Street Journal featured a story on its cover page regarding Computer Associates. A Delaware court invalidated $558 million of stock option compensation that Computer Associates had awarded to three of its senior officers. The forfeiture occurred not because the compensation was excessive, but because of a mistake in the plan documents. The documents omitted a standard provision that adjusts the number of shares available for awards to reflect stock dividends and stock splits. Inclusion of a sentence to this effect would have saved all of the invalidated awards.

Fact: A Federal Appeals Court ruled that a company's resolution promising executive benefits was not a valid promise. The Court ruled instead that a life insurance policy was the governing plan document. This ruling allowed the new management, after a change of control, to eliminate the "lifetime" benefit.

Fact: Executives at a major public company with a funded Rabbi Trust were denied their nonqualified plan benefits following a hostile takeover. The acquiring company had control of the irrevocable assets because of its power as the plan's "fiduciary", and stopped the plan trustee from paying benefits even though a change of control occurred. The plan's drafters had omitted an important provision that would give the responsibility to pay benefits after a change of control to someone other than the company's new management. The affected executives spent 18 months in litigation, amassing ever-increasing legal fees, to fight for their rights.

Fact: After a change in control, executives were surprised to find cutbacks in their benefits due to the golden parachute rules. Many employment agreements and change in control agreements provide for a cutback in severance benefits to the extent necessary to avoid golden parachute penalties. Unfortunately, these executives realized too late that an acceleration in the vesting on payment of benefits from their SERP, Deferred Compensation Plan (DCP), and stock options count against the golden parachute limit and consequently risk taxation of excess benefits.

As we revisit an era of merger mania in corporate America, a dangerous trend has evolved. The executive benefit package has become fair game for acquisition hungry companies. This article examines the vulnerabilities and opportunities in the design of nonqualified plans and the trusts that protect them.

First Line of Defense - Strengthen the Underlying Plan

An acquisition's targeted executive benefit package is only as solid as the quality and competency of the plan documents. Acquirers are looking to executive benefit contracts to reduce the overall costs of acquiring a company. These are not small dollar items - the present value of the supplemental executive retirement plan benefits in a highly-publicized takeover of a $5 billion company totaled over $60 million dollars. If the acquiring company wanted to play hardball with the target employer, it could:

- Slash tens of millions of dollars from the package by creatively massaging the actuarial    assumptions.
- Eliminate the benefit - with the blessing of the Federal Courts - because of a minor flaw in the    plan document.
- Fail to provide funding of the benefit, claming financial hardship.

Few executives address the risks of a takeover, mainly due to false reassurances by the lack of merger activity over the last five years. Even management teams who have played the acquirer role and who have attacked these benefits find themselves woefully under-protected in their own packages.

Rabbi Trusts - Introduction

Surveys show consistent increases in the use of Rabbi Trusts to secure executive benefits. However, a review of Rabbi Trusts in force at various companies reveals troubling facts about the security provided by these trusts:

- Irrevocable? Maybe not. In a review of fifty Rabbi Trust documents, eight were found to be revocable - meaning that the employer can pull the trust assets out of the trust.
- Who makes the decisions after a change of control? In five of the trusts, a committee made up of company officers was named as the trustee. Committee membership was determined by corporate title, placing control of trust assets squarely in the hands of an acquirer in a change of control. In the example mentioned above, the "fiduciary duties" are in the hands of the new management unless you plan for it in the document.
- Preservation of assets. Several documents allowed the employer to exchange assets of "equal" value without specifying the valuation method.

IRS Model Trust Document

The ease for implementation has become compelling. In 1992, the IRS issued a model Rabbi Trust document. The model is a safe harbor so its use is not mandatory. But unless the model language is adopted, the IRS will not issue a private letter ruling on the plan. Of course, the IRS has left open the window that in "rare and unusual cases" they will rule on a non-model document.

The IRS has given companies some latitude to customize the model document to fit their particular situation. There are three types of language specified within the document:

- Mandatory: No deviations allowed - must be adopted verbatim;
- Optional: Can be substituted with employer's own language; and,
- Alternative: Options are provided from which to choose.

Should a company adopt the IRS model? The answer depends upon the level of comfort received from the employer's counsel. Some legal practitioners are unwilling to move from the model language. Others, and the group is growing, are more interested in building a document that meets the client's needs. The best approach appears to be:

- Outline the employer's objectives in setting up a Rabbi Trust;
- Check to see if the model document allows all material requirements of the outline; and,
- If the model does not provide the necessary flexibility, decide with counsel whether sailing out of the safe harbor is prudent.

How Secure is Your Rabbi Trust?

While there is no substitute for competent legal counsel in the trust drafting process, a measure of common sense is warranted. Many executives are shocked to find that the beloved Rabbi Trust into which they place such great hopes has been written to provide little, if any, security. The following list discusses areas that are frequently overlooked:

- Irrevocability: Make the Rabbi Trust IRREVOCABLE. As simple as it may seem, many Rabbi Trusts have been drafted as a revocable trust. Perhaps the reason is that the IRS's model language provides the word "revocable" as acceptable alternate language. However, any security provided by a Rabbi Trust is diminished or eliminated unless the trust is irrevocable.
- Speed of Funding: Rabbi Trusts might be "springing," meaning that assets are transferred to the trust upon a triggering event - usually a change of control. However, if a funded Rabbi Trust is the goal, which is the case for most employers, the document should specify how quickly the trust assets equal the plan liabilities. Many plans now specify that assets and liabilities be matched from the outset. In our experience, most springing Rabbi Trusts never get sprung.
- Levels of Funding: Many trusts do not specify how much value should be in the trusts. Assets in the trust should be sufficient to pay all benefits that would be due upon a change of control. If acceleration of vesting occurs due to a change of control a large infusion of assets might be required to meet the new liability. Participants have more bargaining power if the trust contains these assets before the change of control.
- Provision for Professional Fees: Most trust documents require that trustee, legal, accounting, and other administrative fees will be paid from trust assets. Few trusts, however, provide that these fees, or their estimate, will be funded by the employer up front. Because these fees can quickly eat into trust assets, the document should provide that assets be transferred into the trust to cover these expenses before a change of control. There is really no additional P&L expense for the company to do this.
- Maximum Asset Level: Many Rabbi Trusts are funded with trust-owned life insurance. The death benefits payable on the policies are typically greater than the cash values being counted as trust assets. If a death occurs, the trust may become over-funded, sometimes materially. The trust should provide a funding target percentage that, when reached, allows a return of funds to the employer. The most common percentage is 125% of the projected benefit liabilities.
- Trustee's Use of Fiduciary or Consultant: Trustees are typically experts in managing a trust, however the job of calculating benefit amounts usually falls to a benefit consultant or possibly a company human resource group, and the calculation of benefits is the responsibility of the "fiduciary." Either way, the trustee will be to a large degree dependent upon this "outsider" upon a change of control - and if the administration is done internally, the trustee must start from scratch since the administrator and fiduciary is then the acquiring entity. By naming the benefit consultant and giving the company the right to name an outside fiduciary in the document, maximum protection is reached. Further, the document should provide that after a change of control, trustee and trustee advisor substitutions require the approval of all participants.
- Loans Against and Substitution of Assets: The reason for implementing a funded Rabbi Trust is to provide security. The document should limit or restrict loans from the trust to the employer. Substitution of assets should require that strict rules be followed to avoid atrophy of trust assets.
- Review All Powers Passed to Successor Management: When designing the Rabbi Trust, the employer should require that all powers of successor management (after a change of control) be reviewed thoroughly. Many executives have been surprised at the powers granted to hostile management after the triggering event.

There is no substitute for common sense in the drafting of a trust document. The reason so many companies go astray is their unqualified reliance on legal counsel. In defense of the attorneys, they are asked merely to provide a Rabbi Trust document. The easiest and safest road for them to follow is the IRS model. It is the responsibility of the company management to understand the document and to "stress test" possible issues with an objective of "no surprises."

Funding the Trust

Rabbi Trusts do not enjoy the same tax benefits as qualified plan trusts, which are tax-free until the assets are distributed to the participants. Rabbi Trust earnings are taxed at the sponsoring employer's tax rate, unless invested in tax-exempt vehicles.

This negative tax treatment leads many employers to consider the use of life insurance as the funding vehicle. Preliminary results of a 2003 survey of executive benefits show that over 70% of responding Fortune 1000 companies fund their DCP, of those funded, 55% fund using corporate owned life insurance (COLI) or trust owned life insurance (TOLI).

Since funding with insurance does not guarantee cash availability at the time benefit payments are made, some employers keep a portion of their trust assets in cash or shorter-term investments. While providing a lower after-tax return, this decision can aid in providing necessary liquidity that may be lacking in the longer term insurance commitment. A new concept known as the Pooled Benefit TrustSM (PBT®) would allow the company to monetize the trusts death benefits rather than waiting for the executive to die in the future. This is accomplished by the Rabbi Trust pooling the death benefit portion of the policy with other employers to receive a more predictable flow of cash to the trust. Using the PBT® could increase investment returns over the life of the plan by 100 basis points, annualized.

In 1992, the IRS released a favorable private letter ruling dealing with employer stock purchased by a Rabbi Trust. Some have argued that the use of the employer stock is a weak funding tool, due to the fluctuating value and since it does not match the value of the benefit liability. However, it can serve a useful purpose as a "filler" between the time the Rabbi Trust would be fully funded with other assets and the period during which the employer needs to build those assets. In any event, the issuance to or purchase of employer stock should be closely reviewed by counsel. Recently, some Wall Street firms have issued "hedge contracts" to help offset companies' liability by tracking the underlining asset (i.e. S&P 500 index). These strategies work as fillers, and can even be used to track the employer's stock.

Trust Services

Before the IRS model trust, it was not uncommon to see the trustee for a Rabbi Trust consist of a committee of company officers. Common sense and, requirements within the model trust, have shifted this responsibility to independent, professional trust companies. Most large trust companies have created nonqualified trust departments. However, the choice of trustee must be made with the understanding the trustee will be solely responsible for interpreting trust documents in concert with the fiduciary if there is a change of control. Potential risks include:

- Trustee inexperience;
- Trustee unwillingness to make decision due to legal concerns; and,
- Lack of information with which to make decisions.

All of these risks can be minimized through simple reference checks and interviews. Discussing prospective trustee behavior with references is a good start. A better indicator of trustee experience is to interview a participant covered by a trust (preferably the chief financial officer or general counsel of the acquired company), after a change of control event has occurred.

The trustee will need direction as to the calculation of plan liabilities. Many companies realize too late (after a change of control) that the only source of information is the new management, the very party the Rabbi Trust was meant to defend against.

Protecting Beyond Change of Control

In today's environment with the Enron and the WorldCom debacles, many executives want to be protected beyond change in control. A number of devices provide such protection, including Secular Trusts, Insured Security Option Plan™ (ISOP®), Secured Trust, etc. Some, like the ISOP®, can provide full ERISA protection, thereby giving the participants full protection.

Conclusion

When designing the security arrangement for your company, you should identify what you are trying to protect against: change in control? change of heart? change in financial conditions? bankruptcy?

A well-structured plan is one that is beneficial to the company and the employee. There is more to securing one's benefits than meets the eye. Good plan construction and documentation along with a security device that meets the objectives of the company and the objectives of the executives are important. Equally important are the levels to which the plan is funded.

The best precaution against this is a plan audit of all benefit plans, associated agreements, and insurance agreements. While it is tempting to be pennywise in this context, there is no substitute for eagle eyes and experience. So be sure the audit is not performed by a junior accountant, junior attorney, junior consultant, or anyone else who lacks years of experience focused on compensation and benefits. If you would like additional information, see www.retirementcapital.com or e-mail us at info@retirementcapital.com to discuss the details of your company's executive benefit plans.