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A Process to Evaluate Funding Alternatives
Nonqualified deferred compensation (NQDC) plans continue to enjoy enormous and growing popularity in corporate America. Ninety-three percent (93%) of Fortune 1000 surveyed companies now provide such a benefit to their senior management teams, according to the Executive Benefits – A Survey of Current Trends, 2003 Results by Clark Consulting. NQDC plans are also providing more flexibility when it comes to retirement planning. Most companies now allow covered employees to defer not only a portion of salary into the firm’s traditional 401(k) plan, but also a portion of salary and bonus into the NQDC plan. Multi-fund rates, similar to 401(k) plans are gaining in popularity. Nearly half of the firms surveyed credit NQDC plan account earnings using a variable interest rate. (Exhibit I). Exhibit I With this explosive growth in the prevalence of NQDC plans, a fresh look at important issues, such as funding alternatives, plan security, and investment considerations associated with these programs, is both helpful and timely. Funding Alternatives and Investment Issues Given the dramatic increase in 401(k) plan type investments, the selection of vehicles to adequately fund the resulting liabilities becomes a critical factor. Even though 37% of surveyed companies relying on such investments simply purchase the same mutual funds as their 401(k) plan, the decision isn’t that simple (Exhibit I). In reality, the selection of an investment to fund a NQDC plan should be based on a careful screening process that takes into consideration the company’s needs and goals with respect to: (Exhibit II) ¿
Security; Exhibit II - Security: An NQDC plan should provide security for the benefits promised under such plan by establishing some sort of trust arrangement. Additionally, security is also impacted by the degree of risk associated with different types of investments. For example, the company’s ability to pay future benefits will obviously be impaired with riskier funding vehicles, such as real estate or unregistered company stock, when compared to more stable, conservative investments like annuities or preferred stock. - Up-Front Cash Required: The sponsoring company will want to minimize the amount of capital it must invest in order to adequately fund the plan benefit payouts over time. Investments earning a higher yield require less up-front cash than those earning a lower yield, such as tax-exempt bonds or fixed-rate annuities. In addition, some investments provide for periodic cash payouts over time, rather than significant up-front outlays. - Asset / Liability Matching: Sponsoring companies must assess the likelihood that the value of an investment will keep up with the emerging benefit costs over time. Given periodic changes in market conditions, will the asset value of the investment be sufficient to cover all benefit costs at some future date? This definition should be distinguished from the more traditional use of the concept, which is typically limited to how a company manages the present value of assets and liabilities. What is most essential here is the future value of the investment, and the benefit obligations associated with it over time. - After-Tax Return: In order to minimize
the capital needed to fund the required benefits, the investment
should have the ability to earn the highest after-tax yield,
since over time, a tax-advantaged investment should return
a net amount higher than a similar taxable investment. This
after-tax yield should also be adjusted for risk. Perhaps
the single most important investment criterion, after-tax
return, is also the most difficult to predict and control
over short periods of time. Exhibit Exhibit
The major reason why the deferred compensation account value outperforms the after-tax personal investing is that the asset compounds tax deferred. Therefore, you are receiving the benefit of tax-deferral during the accumulation. - Flexibility: Sponsoring companies should be able to respond quickly to changing levels of benefits. Some examples of these changing levels happen when new participants are added to the plan, actual salaries differ significantly from projected levels, or participants leave the firm through attrition or retirement. These examples suggest the need for investments with high liquidity, flexible deposit options, and the ability to change the asset mix without adverse tax consequences. Another important factor is relative ease in the ability to distribute incremental benefits as they come due. Balance of Issues When choosing an investment crediting rate, each company should base their decision on the relative importance of the five characteristics listed in Exhibit IV. The exhibit analyzes the relative advantages and disadvantages of three popular investment alternatives in the context of these characteristics. A careful analysis of each characteristic, and its relative importance, should allow a company to identify the investment which best meets their objectives. Exhibit IV
1 Assuming “standard” is tax-exempt
bonds Ranking the Alternatives Security: One of the potential problems associated with NQDC plans is that the income deferred by an executive must remain a part of the general assets of the company in order for executives to avoid taxation in the year the income was actually deferred. For most firms, the objective of “informal funding” of their executive benefit plans is to provide participants with a level of security for their NQDC plan benefits comparable with that offered by a qualified plan. As a result, many companies have implemented a variety of alternative funding and plan security devices to assure that any income deferred by executives and interest earned will be there for them at retirement. The Rabbi Trust is one of the most popular security devices used today. Eight-seven percent (87%) of companies surveyed use this type of Trust to protect plan assets against change in control or change of heart by management. Using a Rabbit Trust may be the best way to
accomplish the company’s
objective when it comes to plan security. The first criterion
when choosing a plan investment may be Up-Front Cash Required: Under the terms of the earlier definition, any investment with a high rate of return would score well on the cash requirement factor. Company stock would, of course, require the lowest initial cash outlay. But, as previously noted, unregistered company stock suffers significantly under the security and flexibility factors, making it much less attractive as a benefit funding alternative. A new funding alternative that requires little upfront cash is a “forward hedge.” This is a financial tool that allows the company to buy a hedging contract against the underlying benefit (i.e. SLP 500 index or mutual fund). The cost to the company is usually LIBOR plus 50 basis points. Asset / Liability Matching: In high inflation environments, benefit costs will tend to increase. Thus, one desired investment characteristic would be for the asset value to increase along with inflation. We have assumed that equities (or other vehicles with equity components, such as preferred stock) track inflation quite well over the long-term. Bonds, on the other hand, do not perform well in an inflationary environment. After-Tax Return: While each investment alternative differs in total after-tax return, all three offer the potential to exceed the returns offered on guaranteed fixed rate alternatives. Careful analysis of total return, incorporating such issues as tax effectiveness and timing of cash flows, is required once the field of alternatives has been narrowed based on the resolution of security and flexibility issues (Exhibit IV). Flexibility: Returning to our previous definition of flexibility, investments rank high on liquidity when they can be readily converted to cash. Clearly, all three of our investment examples are considered liquid, however, it is important to be aware of any surrender charges that may be assessed by different funds or policies. Because benefit costs do not always grow in a predictable fashion, the ability to make increasing investments or deposits over time is desirable. Again, all three examples easily pass this test. In terms of the ability to change the asset mix while avoiding adverse tax consequences, our COLI and hedging strategy examples meet this criterion. Specifically, variable life insurance offers an initial selection and reallocation from a broad range of asset classes without incurring taxation on the gains. The hedge is a little more complicated but could provide similar flexibility. Usually the liabilities need to be above $10 million, as most firms will not issue smaller hedges. These asset classes include separate account portfolios invested in common stock, fixed income, and real estate. This tax deferral is possible due to the tax-favored treatment of the cash value accumulation within the life insurance product. On the hedge, for accounting and tax purposes, there is no tax paid until the liability is settled (i.e. hedge accounting). Transferring assets between mutual funds and similar investments, on the other hand, creates a taxable event. There is also a major difference from an accounting standpoint. With a mutual fund, only realized gains flow through the income statement while unrealized gains go to shareholder equity. This becomes a major problem when one tries to maximize the returns, while at the same time reducing the taxable income in the fund. One of the advantages of the Corporate Owned Life Insurance (COLI) product is that it recognizes both through the income statement. As mentioned earlier, the hedge follows hedge accounting. The ability to distribute cash coincides with the timing of benefit payments because COLI is structured to match benefit payments as they become due. In contrast, the managed portfolio, by definition, cannot be structured to match benefit payments nearly as well. The hedge is a little more complex but could be designed to meet timing. Finally, all three examples pass the ease of distribution test, defined as the ability to easily distribute discrete “pieces” of the investment when funding benefit payments. Conclusion Based on the foregoing ranking process, all three alternatives stand out as excellent candidates for helping a company fund its NQDC plan benefits. In this light, it is not surprising that sixty percent (60%) of companies that fund their deferred compensation liabilities currently use COLI, while thirty-two percent (32%) use mutual funds (Exhibit V). Organizations are using both options in a strategy that funds short-term costs with mutual funds, and long-term costs with COLI, thus smoothing cash flows from the plan. The choice between these two alternatives should hinge on the assessment of each investment’s risk-adjusted return. The hedging strategy is also being used in connection with COLI, although this is fairly new. Because the scope of this article limits an evaluation of other investment alternatives, we chose instead to focus on the three options most popular among companies. There are numerous other investment alternatives to select from. Regardless of the investment vehicle selected, the overall process outlined above can provide companies with a high degree of confidence, knowing that all the significant issues affecting the overall security of their executive benefits have been taken into careful consideration. Exhibit V
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