Featured Articles |
RCG Extras |
Join Our Mailing List |
Compensation Committees Need to Evaluate Company SERPsSupplemental Executive Retirement Plans Are Under the MicroscopeWilliam L. MacDonald
Over the last 20 years, executive retirement benefit delivery has shifted from qualified plans to nonqualified. Historically, nonqualified supplemental executive retirement plans (SERPs) were created in response to the limited amount of retirement income an executive derived from his or her 401(k) investment or company-sponsored pension plan. As companies designed attractive executive compensation programs, variations of the following nonqualified plans were implemented:
The original premise of nonqualified plans was that they would restore benefit contributions and defer taxation until retirement when tax rates would presumably be lower. To partially secure benefits, many companies chose to fund the plans with Rabbi Trusts. Defined benefit pension plans were a staple of corporate retirement delivery. However, defined benefit plans and defined benefit SERPs began to lose favor because:
Consequently, many qualified defined benefit plans were updated to become cash balance and/or were modified to become defined contribution approaches. However the Defined Benefit SERPs that worked in tandem with the qualified plans were generally not immediately redesigned, and we are just now seeing companies reevaluate their nonqualified defined benefit SERPs and examine methods to update/retool them. As mentioned above, the new proxy rules have heightened the visibility of these arrangements making compensation committees dig a little deeper to understand these arrangements. Changes shouldn’t be made solely on proxy disclosure rules. The right solution will depend on a balance of several factors (Chart I).
Shareholder Groups Focus on SERPsThe hue and cry from shareholders over “excessive” executive compensation continued in 2007. In recent years, an increasing number of shareholder activists in the public and private sector expressed their dismay by filing specific proposals to restrict or reform executive compensation at corporate annual meetings. Most of those proposals did not pass, although some companies did restructure stock plans and equity payouts to executives at the urging of shareholders. Another practice shareholders are particularly concerned with is the use of SERPs for senior executives. As mentioned earlier, SERPs provide pension payouts for executives beyond the IRS limits for qualified plans, and are often part of an executive’s employment agreement with the company. Many SERPs provide benefits above the company’s qualified plan limits. As reflected in Chart II, 42% restore lost benefits while 11% provide a higher level of benefits.
Shareholder activists, such as Lucian Bebchuk, are starting to focus on the issue. Bebchuk, a professor at Harvard University Law School, has submitted binding proposals to several companies to limit the type of pay that can be included in the calculation of supplemental retirement benefits for senior executives. Companies like Bristol-Myers Squibb asked the SEC for permission to omit the proposal, contending that their compensation committee charter already substantially implements the terms requested in his proposal. Similar proposals have been sent by Bebchuk to American International Group (AIG), which would require 75 percent approval by independent directors. Home Depot and Exxon Mobil adopted the amendment to their bylaws, stating in Article II, Section 6, “Notwithstanding the foregoing of two-thirds of the independent directors (as defined in the Company’s Corporate Governance Guidelines) shall be required to approve any compensation granted to the Company’s Chief Executive Officer.” The voice of shareholder activists are being heard from all directions on the subject of SERP benefits (Chart III).
SERPs Provide Competitive Advantage in Attracting TalentIn today’s competitive world, and given the volatility of the stock market, a company’s retirement benefits package might make the difference in attracting and retaining key employees. However, a qualified plan, such as a 401(k), has rules and restrictions prohibiting “highly compensated” executives from saving as much as they may want to in order to feel comfortable about their financial security in retirement. Employers can make up this difference by offering a nonqualified deferred compensation plan, such as a SERP. Most executives view this as a meaningful benefit, and properly designed and funded it should have little cost to shareholders and help the board in attracting and retaining people who can make a difference. What is a SERP? A SERP is a nonqualified deferred compensation plan that allows employers to provide retirement benefits to key employees beyond those provided by the qualified plan. It is an effective way for an employer to supplement an executive’s retirement compensation. These plans have been designed to provide executives with a retirement benefit equal to 60% - 70% of their final average total compensation at the time of retirement. Vesting schedules can help put a little glue in the seat to help companies retain these executives or restrict them from going to work for a competitor. SERP and deferred compensation arrangements have been used to balance a company’s compensation and benefit strategy (Chart IV).
These arrangements may be structured in a much different way going forward, perhaps with more focus on performance. The SERP, designed properly, can work in concert with the overall compensation and benefits strategy.
New Environment for Nonqualified PlansNonqualified plans began to attract IRS/Congressional attention because the plans evolved to broader participation, significantly increasing benefits, and substantial funding. The nonqualified market became very sophisticated and progressively transferred greater control/security to executives through various plan provisions and trust structures. Enron, WorldCom, and perceived executive compensation abuses attracted greater visibility to these arrangements and led directly to new regulations and legislation. In response to the increased visibility of nonqualified plans and the perceived need for intensified corporate governance, there has been a series of limitations to nonqualified plans either made or proposed (Chart V). The pending legislation that places new caps on these plans, along with the proposed expansion of 162(m) limitations (“once a proxy officer, always a proxy officer”), could be the final blow.
The Changing Tax EnvironmentA premise of most nonqualified plans was to defer taxation until rates would presumably be lower. Consequently, executives have assumed an over-concentration of tax-rate deferral risk (since it may be that current tax rates are lower than post-retirement tax rates will be). Combined marginal income and capital gains tax rates are at an all-time low; if rates increase, it may prove inefficient in the long run to defer into what could prove to be a higher tax bracket (Chart VI).
In this new environment companies can redesign these plans to provide a meaningful benefit to its executive group, perhaps reduce shareholder cost and tie the benefits to company objectives.
Corporate Reaction to New EnvironmentWith the adoption of new legislation under IRC §409A and the increased cost of SERP- type programs, companies are reacting to this new environment. First, companies are amending plans to comply with §409A (e.g., eliminating hair cut provisions, distribution discretion, etc.). Under the new proxy disclosure requirements, they are modifying their proxies, which seem to generate a little “shock and awe” as it relates to the size of these benefits. Some companies are eliminating qualified defined benefit plans and analyzing what to do with their nonqualified defined benefit SERPs. Those keeping the DB SERPs are analyzing methods to reduce and diversify executive tax rate deferral risk and look to lower the corporation’s expense. This is being done though defined contribution plans, many of which tie contributions to performance measurements. And finally, some are updating defined benefit SERPs with a conversion to defined contribution approaches, Q-SERPs, and/or after-tax Roth-type plan options.
Analytic Process for SERP Plan UpdatesThe compensation committee should adopt a process to analyze the current SERP to see if it is still meeting the company objectives, and to determine if it is being done in a cost-effective manner. Chart VII outlines a process that starts with quantifying the current plan and takes the committee through the entire due diligence process.
SummaryCompanies today have limited tools to attract and retain the talent that is needed to make a competitive difference. SERPs will continue to be a valuable tool used by companies; however, based on new legislation, proxy disclosure and the cost of providing such benefits, the design features will often need to change.
Investors should consider the investment objectives, risks and charges and expenses of the contract and underlying investment options, risks carefully before investing, The prospectus contains this and other information about the investment company and must precede or accompany this material. Please be sure to read it carefully. The opinions, estimates, charts and/or projections contained hereafter are as of the date of this presentation/material(s) and may be 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. Securities Offered Through Retirement Capital Group Securities,
|
