Deferred Compensation After 409A -
Deal or No Deal?
Chocolate or strawberry instead of plain vanilla?
William L. MacDonald
Chairman, President & Chief Executive Officer
Retirement Capital Group, Inc.
We want to begin with an observation that is perhaps counterintuitive and certainly contrary to what appears repeatedly in the press. Were deferred compensation arrangements working as intended? If so, then why are the rules changing through new legislation?
Before we answer these questions, let’s review how executives are being compensated and how deferred compensation has fit into their overall plan. Historically companies have tried to attract, retain, and reward executives and other key people while at the same time trying to align the offered benefits with the goals of the shareholders. The big currency was stock options, however, now that they have to be expensed under FAS 123, they are no longer the cheap currency they once were. It seems everything a company has tried to do for its executive group is looked at as egregious.
Pay For Performance – Stock options
Today, the pay for performance mantra continues to roll off everyone’s tongue. The idea seems to be that executives should make money only if the company’s stock price went up during the year. That same thinking led to the use of stock options – to align the interest of management with the interest of shareholders.
Shareholder activist groups are the folks who pushed for stock option compensation schemes during the last half of the 1970’s when the markets had been flat throughout the decade. Now we hear that these very options that shareholders wanted to be in the hands of senior managers lead to abuse because executives will do anything to raise the stock price for their personal gain. Some suggest executives receive too many options. “Too many options?” “Too much money?” Perhaps we should consider allowing voters to decide how much compensation is too much. Why stop there…let’s just let Congress decide.
Pay For Performance – Deferred Compensation
Now turning to deferred compensation, it unquestionably aligns the interest of executives with those of shareholders. Now it too comes under fire. These plans are the most benign of all compensation methodologies. Their use causes no dilution in ownership, nor does deferred compensation cost the company any significant dollars to provide the executive plan. In a deferred compensation arrangement, executives are offered the option of deferring “their own compensation” – that is to say, they don’t receive their “own money” until some future date, often at or near retirement. The monies deferred go into the company’s coffers and are subject to the claims of creditors should the company fail. Because they do not receive the money deferred, executives are not taxed on these amounts until they withdraw.
This arrangement is similar to that provided by a 401(k) plan, with the exception that no guarantee exists that when the money becomes due it will be there. What sounds more risky than that? Yet the IRS has worked for the last four years issuing legislation (409A) to restrict various deferred compensation programs, because they say Enron executives used their deferred compensation accounts to get away with riches while Rome burned.
What happened at Enron is not systemic – it is unique on a historical scale. Nothing like Enron has happened before and, like the real Titanic, we are not likely to see a repeat performance any time soon. New corporate villains will be in our future, to be sure.
To enact legislation based on this type of event is not understandable, however, at least now there are specific rules, which should provide more flexibility than prior to the legislation.
Even with the new legislation, nonqualified plans will still be an important part of an executive’s total compensation package, allowing the executive an opportunity to continue to save money on a pre-tax basis with none of the government limitations imposed on the company’s 401(k) plan ($15,500 in 2007). Looking at the new restrictions or opportunities executives will have to answer the question – Deferred Compensation – Deal or No Deal?
Deferred Compensation Under 409A – Deal or No Deal?
Let’s explore this by looking at two hypothetical executive situations, to see the options available, as there may be more than one approach to accumulation dollars for retirement.
Our first executive, Frank Jones, age 48 works for fictitious Apex Corporation; an eight billion dollar market cap NYSE traded company. He has two children, Frank Jr., age 14, and Amy, age 12. Above providing for his family, he would like to retire at age 62.
Executive number two is Bob Carter, age 43, and also works for a similar size company, our fictitious MTA Telecom; albeit, the company is in an industry that is not as stable as Frank’s company’s industry. Bob is also married with two children, Bob Jr. and Sara, ages 8 and 10.
Both men are doing well financially and would like to accumulate money in a tax effective manner.
The following are options they have based on the particular programs their companies offer.
Three Phases of Retirement Planning
Before we jump into the analysis, it might be helpful and important to understand the phases for accumulating dollars for retirement.
Phase One – Contribution
During the contribution phase an individual faces a number of decisions. Not only does an individual need to decide how much to contribute, he must also determine whether these contributions should be made pre-tax, after-tax, or a combination of both. Qualified plans have limits further complicating the issue. Although we have always been told pre-tax investments are better, this is not always the case. Take real estate as an example, your purchase is with after-tax dollars, but you accumulate it tax-deferred and when you sell it you pay capital gains.* We all learned at an early age the adage, “a penny saved is a penny earned”, but how that penny is saved is probably more important than the act of saving itself.
*Investing in real estate involves specialists such as potential illiquidity and may not be suitable for all investors.
Phase Two - Accumulation
While the money is accumulating, the rate at which the money grows (Return on Investment or ROI) directly affects an executive’s retirement life style. Modern Portfolio Theory (or Portfolio Management Theory) subscribes to diversification. Diversification is why individuals invest in mutual funds. Since we all know never to “put all our eggs in one basket”, this course of action makes perfect sense.
Phase Three - Distribution
Since the distribution phase could rest far in the future, planning now for maximum distribution flexibility is key. Funds available for distribution typically fall in one of three categories:
How you obtain your money at retirement may be more important than how you contribute it. Taking distribution under capital gains is important. Pre-tax deferrals could have a negative impact on your retirement income, especially if they are taxed as regular income at distribution.
Conclusion
Diversification in how funds are accessed during the distribution phase is just as important as diversification in the allocation of funds. Some portion of your investments should be designed to provide a hedge against higher tax rates.
Since no one can accurately predict future tax rates, it is important that accumulated wealth should not be dependent on any single asset or assumption. An increase in the top tax rate from 35% to 52.5% reduces your distribution assumptions by roughly 25%. Retirement age is a terrible time to be forced to reduce distribution assumptions. One needs to reduce the tax risk on distribution as much as possible. No one can accurately predict the future of top tax rates in the United States. Just look at the history of U.S. Top Income Rates (Chart I). Do you think rates will go up or down in the future?
Chart I
Case Study- Deferred Compensation vs. ISOP®
Frank’s employer offers him a “pre-tax” nonqualified deferred compensation plan (DCP) as part of his total compensation package. The DCP was designed to provide a great deal of flexibility to help participants meet lifetime goals, such as college savings for their children and retirement.
Frank’s DCP allows him to defer up to 80% of his salary and 100% of his bonus. The new law (409A) requires him to make his salary deferral election before the calendar year begins, however, on his bonus, he can wait until six months prior to the end of the plan’s performance period, which in his case is June. When making his election to defer, Frank has an opportunity through a unique design feature in his plan to set up “buckets” indicating when and how he would like to take distribution.
To meet his personal goals, Frank has decided to defer 12% of his salary and 20% of his bonus, a total deferral of $41,000. As illustrated in Chart II, he has set up five “buckets”. He defers 20% of his contribution for Frank Jr.’s college into the first bucket, and has elected to take four payments starting in 2011. The second bucket was set up for Amy who will start college in 2013. Once Amy finishes college, Frank and his wife would like to start planning for retirement, and they would like to own their own boat, so a bucket has been established as “Frank’s boat account”, and he will take a single payment in 2016.
The final two buckets have been set up for retirement. In the first retirement bucket, Frank is electing to take that one in a lump sum, so he can take a little money off the table. This is a common election, as these plans are subject to the claims of the company’s creditors and he doesn’t know who will be running the company in the future when he has retired. The second retirement bucket was designed to take payments over 15 years, with interest earnings on the unpaid balance.
Chart II
Frank’s plan, gives him the ability to re-defer any payment. All he needs to do is make the re-deferral election at least one year prior to taking distribution, and make sure his new deferral period is at least five years out. Therefore, if Frank Jr. earns a scholarship and the money is not needed for his education in 2011, Frank can either move the money to his retirement buckets, or set up a new one after 2016.
The plan offers 14 investment choices called sub accounts, including the company’s stock. Each bucket can have different asset allocations to help meet his objectives. Frank can be conservative with the buckets for college and retirement, and more aggressive with the boat.
Knowing how busy their executives are, Apex Corporation uses its advisor’s designed model portfolios (Chart III) in their plan, so all Frank needs to do is fill out a short risk tolerance questionnaire and it will help select one of the portfolios for each of his buckets. The portfolios are then re-balanced monthly.
Chart III
Apex Corporation made the decision to fund their plans, by placing assets in a Rabbi Trust helping to protect the assets against a change in control of the company. The only risk Frank has is if the company filed for bankruptcy, which based on their financial strength, it is not a big concern to him.
Now turning to Bob, his employer MTA Telecom has set their executive deferred compensation plans up using an “after-tax” approach. The company began their design process by surveying their senior management team and found that many had a concern with deferring their compensation into a plan (similar to Frank’s) that would be subject to the claims of the company creditors. In addition, MTA did not want to have any liabilities on their balance sheet for such a plan.
MTA Telecom reviewed its alternatives, and selected the Insured Security Option Plan (ISOP®), which is designed as an “after-tax” plan (deductible by the company). However, the method they use to fund it offers participants the most value during the accumulation and distribution phases.
Because the plan does not fall under the deferred compensation rules imposed by 409A, Bob did not have to make any distribution elections at the time of his deferral.
Like Frank’s plan, the ISOP® allowed up to 80% of salary and 100% of bonus deferrals, however, Bob could wait until the day he received his bonus to make his final election, and that is what Bob did. He decided to defer $100,000 of his bonus as he had already set up college funds for his children outside of the company. Bob’s $100,000 contribution was run through payroll, netting $60,000 as his after-tax contribution to the ISOP®.
The ISOP® utilized an employee-owned trust that provided all participants with ERISA protection. Because contributions were made with after-tax dollars, it was important to focus on the accumulation and distribution phases to maximize the plan’s values.
Bob’s $60,000 contribution made to the trust, purchased an institutionally priced variable universal life insurance policy with the full $60,000 invested in the policy, and an initial net death benefit of $1,846,232 with his wife as beneficiary. The policy allowed Bob to choose from a number of sub accounts within the policy, similar to Frank’s plan.
To help maximize the value during the accumulation period, the ISOP® uses a mechanism allowing participants to create the power of the pre-tax contributions.
The insurance policy used to fund the ISOP® has a unique policy rider that may be accessed in the amount of $40,000 to remain in the policy, bringing the total cash value up to $100,000, Bob’s pre-tax amount.
The $40,000 added by the insurance carrier is a non-recourse “policy loan (a)”, however, assuming the policy is held until maturity, Bob does not pay it back until his death (b) – it is simply deducted from the policy’s death benefit upon his death. The policy’s loan interest rate or carrying charge is just an indexed 90-day LIBOR + 1.5% (5.5% on 7-24-06), which is roughly the Prime rate minus 1.5%*.
Because of this unique rider, Bob has a similar opportunity as Frank, during the accumulation period, to invest on the pre-tax amount (i.e., his $100,000), however, he has an advantage during the distribution phase.
Because the ISOP was structured as an after-tax plan, Bob has the flexibility of withdrawing cash from his policy without limitations whenever he wants, he doesn’t need to do any pre-planning.
During the distribution phase, because Bob paid his tax up front, all his contributions are taken from the policy tax-free. He then can withdraw all of the earnings through a policy loan without interest cost**. Therefore, the ISOP® provides Bob with a stream of non-taxable income, similar to a Roth IRA. He has provided a hedge against income tax risk by using the ISOP®.
*Policy loans, the interest accruing on these loans, and withdrawals reduce available cash value and reduce the death benefit or cause the policy to lapse. Policy’s value will also be affected by the performance of sub accounts which, due to market volatility, may go up or down.
**If withdrawals go over basis they will be subject to taxation.
Pre-Tax Deferred Compensation vs. ISOP®
To do an “apples to apples” comparison, we will use the same pre-tax deferral amount of $100,000, and we will assume the executive will defer for 7 years and earn 8% interest net of policy fees and expenses. We will also assume he will take his benefits over 15 years starting at age 65, and will die at age 80.
As you can see in Chart IV, at retirement the ISOP® has $1,709,479 of net cash value as compared to the after-tax account balance in the deferred comp of $1,834,141, assuming income tax rates stay the same. The deferred compensation plan pays an annual after-tax benefit of $198,409 for 15 years, as compared to a $169,208 non-taxable death benefit under the ISOP®. In addition, with the ISOP®, the participant’s beneficiary will receive a $1,667,606 tax-free life insurance death benefit; assuming death age 80.
Note: The hypothetical example above is dependent on the assumptions presented. Investors should be aware that policy values and death benefit amounts are subject to market risk and it is possible to lose money due to market volatility. Loans, interest and withdrawals will also affect policy death benefits and policy cash value.
Chart IV
From a company’s funding standpoint, the ISOP® should be less expensive from a net present value basis.
This hypothetical variable life insurance illustration is based on the assumptions presented and should not be used to predict or project investment results. Loans, interest accruing on loans and withdrawals reduce available cash value and reduce the death benefit or cause the policy to lapse. Actual returns may vary.
Conclusion
When planning for retirement employing deferred compensation packages, an executive needs to consider the impact during the three phases (Contribution, Accumulation, and Distribution) and weigh all of the risk factors with each. Several risks can undermine the success of an executive’s retirement income. These include longevity, inflation, asset allocation, tax rates on retirement income and health care expenses.
As executives plan for retirement, they must plan for the moves from a period of asset accumulation to one of distribution planning. The impact of this shift cannot be overestimated because these nonqualified plans represent a significant portion of their future income.
Investors should discuss their own unique situation with their tax and financial professionals. RCG does not give legal or tax advice and the opinions presented in these materials should not be construed as such. All examples are hypothetical and not intended to represent any specific investment.
The ISOP® uses a variable universal life insurance policy called the Lincoln Corporate Variable 5 Life Insurance policy (LCV5). It is issued by the Lincoln National Life Insurance Company, Fort Wayne, Indiana.
Policy Form Number LN939.
Investors should consider the investment objectives, risks, charges, and expenses of Lincoln Corporate Variable 5 life insurance policy carefully before investing. This presentation must be accompanied by or preceded with a current prospectus. Please read the prospectus carefully before investing.
The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and maybe subject to change without notice. RCG endeavors to ensure that the contents have been compiled or derived from sources RCG believes to be reliable and contain information and opinions that RCG believes to be accurate and complete. However, RCG makes no representation or warranty, expressed or implied, in respect thereof, takes no responsibility for any errors and omissions contained therein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this presentation/material(s) or it contents. Information may be available to RCG or its affiliates that are not reflected in its presentation/materials(s). Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any investment product. Investing entails the risk of loss of principal and the investor alone assumes the sole responsibility of evaluating the merits and risks associated with investing or making any investment decisions.
This report contains proprietary and confidential information belonging to RCG (www.retirementcapital.com). Acceptance of this report constitutes acknowledgement of the confidential nature of the information contained within.
Securities Offered Through Retirement Capital Group Securities,
a Registered Broker/Dealer, Member FINRA/SIPC
William L. MacDonald, Registered Representative - California Insurance License #0556980
Retirement Capital Group Securities, Inc. is a wholly-owned subsidiary of Retirement Capital Group, Inc.
|
RSS | Terms of Use | Privacy Policy | Legal Disclosures and Business Continuity | Site Map