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Cost-Effective Executive BenefitsWith the Adoption of SFAS 123R Regarding the Expensing of Stock Options, Companies are Utilizing Executive Benefits as Cost-Effective AlternativesBy
William L. MacDonald When people discuss executive compensation, they usually only discuss half the story. They tend to focus on the cash and equity side of the equation and forget about executive benefits (Chart A). Chart A Executive benefits should fit into a company's integrated total rewards program. In light of recent accounting issues with stock options and restricted stock, executive benefits are more cost-effective than many equity-based programs. Executive benefits and perquisites include deferred compensation, supplemental executive retirement plans, financial counseling, as well as supplemental life and disability insurance. This article gives an overview of executive benefits. It outlines specific plans, and finally concludes with Retirement Capital Group's Six-Step Process for determining the appropriate programs in a compensation and benefits strategy. It explains why one size does not fit all and how a company can use executive benefits to balance its overall strategy. Overview of Executive Benefits Executive benefits are often looked at as "extra compensation"; that is payment over and above salary, bonus, and equity. Consequently, boards, shareholders, and the media alike are scrutinizing executive benefit plans more than ever before. It is, therefore, important to have an objective basis and process for determining which of the many possible benefits make good business sense, as well as how they may help or hurt an organization's ability to attract, retain, reward, or motivate those key employees who can make a difference. Recently major economic
reasons have increased the For the last five years the stock market has been down. There have been massive layoffs, hiring freezes, lower bonuses, and in many cases no long-term incentive payouts or major appreciation in stock options. On top of all of that, FASB, the governing body for accounting, has mandated the expensing of stock options for public companies for financial reporting periods after June 15, 2005 (SFAS 123R) (Chart B). Many companies are treating the change as an opportunity to refine and optimize their total compensation programs. This has lead companies to turn to executive benefits as another alternative that just may be more cost-effective for shareholders. Chart B After Enron's financial downfall, a flurry of new legislation on executive pay and benefits has been enacted. Moreover, the media has produced sensational stories on what it sees as excessive pay packages. And then, of course, the new sheriff in town, Sarbanes-Oxley and one of his deputies, the Section 409A (deferred compensation legislation) have been tightening the guidelines regarding executive benefits. Companies struggling to re-build their levels of profitability and growth need to compensate their executives even more so than would be required when times are flush. More difficult times of leadership require better compensation packages. With the big issue of whether or not to expense stock options in the past, and the need to align the interest of executives with those of shareholders, executive benefits may be the cost-effective alternative for which we have been searching. All of this has lead to an environment of restraint, or at least reconsideration of some of the packages and programs already in place. So, how is one to determine what packages of benefits are best-suited for a given company- that is, those which are necessary and in-line with the overall executive compensation philosophy and are likely to add value to shareholders? This article explores the needs of the three major constituent groups (employer, employee, and shareholder) and evaluates trends and best practices. Each of the most prevalent benefits techniques are examined and this article looks at the general purpose, objectives, prevalence, structure, tax impact, cost, and cash flow considerations. Where do executive benefits and perks fit and why? Most compensation and benefit programs were designed and structured to meet a company’s business purpose. Few companies, however, have designed them to work in concert with their overall compensation strategy. The total rewards strategy, which must cover all elements, should support the overall business strategy. Executive benefits can help to counter the reverse discrimination in core benefit plans (401(k), retirement, life, and disability) imposed by government limitations. Supplemental executive plans can be structured to add additional rewards on retention by deferring salary, bonus, and long-term incentives. What are the elements of executive benefits and how do they work? Nonqualified Deferred Compensation (NQDC) Deferred compensation is at the core of executive benefits. It can be one of the lowest cost benefits that align the interest of executives with those of shareholders. The use of deferred compensation causes no dilution in ownership, nor does it cost the company significant dollars to provide. In a deferred compensation arrangement, executives are offered the option of deferring their own compensation into tax-advantaged accumulation accounts. (Chart C). These accounts are composed of the same compensation dollars that would have otherwise been paid in salary or bonus. Chart C
A typical NQDC plan allows executives to defer eighty percent (80%) of their base salary and one hundred percent (100%) of their annual incentive awards. The deferrals accumulate and grow at a set rate of interest or at a rate of return determined by some form of investment, such as a mutual fund. For many companies, the primary objective of these programs is to provide an additional vehicle to facilitate wealth accumulation, as well as tax and portfolio management opportunities. A NQDC plan can be a valuable tool that aligns the interests of shareholders with those of management. A company may use such a plan to attract key employees. The plan can serve as a parking place for signing bonuses with "golden handcuff" vesting requirements. Finally, a company may use such a plan as a retention tool offering a company match that vests years in the future. The reason these plans are so prevalent is that the cost of offering such an arrangement is negligible due to the use of various funding vehicles (Chart D). Yet these plans provide executives with the advantage of tax-deferred savings and investment growth. Chart D
Assumptions: 1) $20,000 annual pre-tax contributions 2) 15 years of contributions 3) 40% tax rate 4) 7.0% return net of IMFs 5) 100% turnover in taxable investment Excess Benefit Plans Two types of excess benefit plans are available but both restore lost qualified retirement benefits due to legislative limits. Excess benefit plans, like a deferred compensation plan, are nonqualified; meaning they are exempt from the filing, reporting, funding, and fiduciary requirements of ERISA (Employee Retirement Income Security Act). The first type of excess benefit plan restores benefits due to IRC Section 415 limits. This plan is referred to as a restoration plan and simply compensates for lost qualified plan benefits. For 2005 the defined benefit plan limit is $170,000 (IRC § 415(b)). The defined contribution plan limit is $42,000 (IRC § 415(c)). These plans can be in either a defined benefit form, as a supplement to a qualified pension plan, or in a defined contribution form that may, for example, restore benefits contributions in a profit sharing or 401(k) plan. The second type of plan restores benefits that are withheld due to compensation limits (IRC § 401(a)(17)) imposed on qualified defined benefit and defined contribution plans. In 2005 the compensation limit under this section is $210,000. This provision could significantly lessen executives’ qualified plan payments, particularly those of the top echelon of executives who often earn well in excess of these limits. Supplemental Executive Retirement Plans (SERPs) SERPs are nonqualified plans that do more than restore excess pension plan benefits. These plans can provide additional benefits by applying to a different definition of compensation (e.g. includes annual incentives on other compensation). Furthermore, they can offer more advantageous provisions than those offered by qualified plans. Some of the typical feature enhancements include an alternative benefit formula, different accrual pattern, or different early retirement features. A SERP can be very flexible in design. It can take on the form of either a defined contribution or defined benefit plan. In addition to the objectives of retirement income security and wealth accumulations, SERPs are often designed to achieve other objectives such as providing an attractive recruitment tool, rewarding for performance by linking to company performance goals, and being used as a retention tool. SERPS are often considered to be the most effective type of supplemental retirement program because of their inherent flexibility. The prevalence of "performance-based SERPs" has increased as they have proven to be more cost-effective than stock options or restricted stock with no dilution. A company can zero in on the type of performance it requires; that is, increased margins, cash flow, net earnings, EBITDA (earnings before interest, taxes, depreciation, and amortization), or earnings per share. Supplemental Life Insurance In connection with sound financial and estate planning, life insurance programs that provide income replacement are not uncommon programs at executive levels. Most basic group plans offer limited opportunity to provide significant levels of death benefit protection. The disconnect between a company's life insurance policy and its total compensation and benefits strategy occurs when the bulk of an employee's compensation is derived from bonus and incentive pay, while the group life plan delivers a benefit based on a multiple of salary (i.e. one and a half [1.5] times the salary with a cap of $200,000). As a result, companies that offer a total compensation package that emphasizes security and flexibility should consider providing supplemental life insurance protection as a multiple of total compensation for its top management (i.e. three to five times the total pay with no cap). Executive Long-term Disability Similar to group life insurance, group disability plans have limitations and often exclude total compensation. The group disability plans also offer a multiple of salary with some monthly cap (i.e. 66.67 of salary with a cap of $15,000). They have the incorrect definitions of disability to cover an executive's responsibilities, etc. Today companies are designing supplemental plans to fill the void and base the benefits on total compensation, as well as the value of stock options. Perquisites Perks come in many shapes and sizes: access to corporate aircraft, country club dues, car allowances, etc. However, one of the fastest growing perks that helps to tie everything together is financial counseling. With the ever increasing complexities associated with financial planning and the myriad of investments now commonly used by even the average employee, it is no wonder financial counseling and financial planning services are a valued benefit to any executive. In fact, roughly one-third of companies currently provides some form of assistance to their executives according to a 2004 Clarke Consulting study. But do financial counseling services achieve any objective other than something valued by the recipient? Actually, they do. Along with providing access to a program that can be perceived as having value and status, financial counseling services can aid in ensuring that an executive is focusing his attention on the company’s business, secure with the knowledge that his personal finances are in order. Financial counseling and planning can also substantially enhance an executive's appreciation and understanding of the value of the total compensation package as offered through company-sponsored benefit programs. Summary and the Retirement Capital Group Six-Step Process So how is the right set of executive benefits and perquisites chosen? The following steps can help determine how these programs fit within the total compensation package.
2. Because executive benefits for the most part are nonqualified, examine the various security devises available to provide a benefit that has perceived value (i.e. Rabbi Trust). During this step the company must also analyze the cash flow and profit and loss impact to guarantee a plan is designed that is cost-effective to shareholders. 3. Obtain the Board of Directors approval and formally incorporate the program, its purpose and objective, eligibility, structure, and administration/monitoring requirements of each program in the total compensation and benefits strategy. 4. Implement the plan - the best made plans can be ignored or undervalued if not communicated properly and frequently. Implementation and communication are important elements. Many firms use web-based enrollment, financial counseling, and other tools to properly communicate the plan. 5. Select vendors and administrators to insure program communications, tracking of program cost, etc. Look to existing vendors (i.e. the company’s current 401(k) provider) to coordinate executive benefits with existing programs to offer a more seamless benefit statement. 6. Monitor the plan - in the ever changing world of compensation benefits, tax, and legislative changes working with a competent group will pay major dividends over the long run. The information provided is general information for reference purposes only, and should not be construed as advice in any respect. Please consult with your legal counsel or tax advisor in order to assure thorough and proper application of the complex rules that are highlighted here. |
