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First Line of DefenseDeveloping Compensation and Benefit Strategies for Direct ResultsWilliam MacDonald discusses the cost-effective advantages of a strategically centered and integrated executive benefit program and how it can motivate key executives to define and deliver outstanding performance to companies and shareholders. By William L. MacDonald
Your ability to attract and retain key employees in this volatile stock market is more difficult than ever before, especially if you focus solely on equity compensation. Certainly, equity compensation motivates employees. But the real question—motivates them to do what? To ensure that equity compensation is effective, it must influence and shape the desired behavior across the enterprise. Ask yourself: How do I want equity compensation to motivate performance; what do I want them to do? If they think llike owners, it is reasoned, they will protect the company, worker harder, and reach goals. Somewhat like owning a car, you’ll take better care of it. On the flip side, if you rent it, you won’t wash it. Truthfully, most executives do not want to think like owners. If they did, they would suffer through the pain of building a company. They do, however, want owner-size compensation. In reality, most executives are shaken by the stock market rollercoaster, and the unsettling queasiness that they have no control over corporate stock value.
Buffett on Bonuses Even the sage himself, Warren Buffett, has said that there is little managers can do to affect stock price. In public commentary, he maintains that if a company continues to reinvest in itself, stock price will naturally track with return on equity. To underscore Buffett’s contention, he constantly reinvests in his companies, and prefers to give managers annual bonuses that are linked directly to how well they deliver results above return on equity. After all, why enrich anyone with prized stock options if they aren’t directly producing results? When professionals consider executive compensation, they usually work on only half the equation. The focus tends to settle on the cash and equity side of the equation and executive benefits are often conspicuously absent. Chart A
Building Best Practices In a best practices world, executive benefits should fit hand and glove into a company’s total rewards program. Over the last few years, companies have addressed these issues with stock options and restricted stock. Today, however, many companies have found that executive benefits are more cost-effective than many equity-based programs. By example, these executive benefits and perquisites may include deferred compensation, supplemental executive retirement plans, financial counseling, as well as supplemental life and disability insurance. This article offers an expanded view on executive benefits. It outlines specific plans, and shares Retirement Capital Group’s process for determining the appropriate programs in a compensation and benefits strategy. Further, we explore the needs of three major constituent groups (employer, employee, and shareholder), and look at general purposes, objectives, benefits prevalence, structure, tax impact, cost, and cash flow considerations. We briefly touch on trends and best practices, and identify why—when addressing executive benefits—one size does not fit all.
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 scrutinize executive benefit plans more closely. That’s why it is so important to apply an objective basis and process in determining which of the many possible benefits make sound business sense. Equally important, you must evaluate how these benefits 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 refocused attention on executive benefits and perquisites”
Market Forces These measures come on the heels of FASB, the governing body for accounting which mandates the expensing of stock options for public companies. For financial reporting periods after June 15, 2005, SFAS 123R mandated that stock options be listed as a corporate expense on the balance sheet, thus causing a sweeping reconsideration of the practice. Since Enron’s financial downfall, a flurry of new legislation on executive pay and benefits has been enacted. Expectedly, the media has opined sensational stories on what it interprets as excessive pay packages. And, sometimes, they were right. Then, a freshly minted sheriff arrived in town, Sarbanes-Oxley, along with one of its deputies, IRC Section 409A (deferred compensation legislation) and pulled the reins on executive benefit guidelines even tighter. These developments have created an environment of restraint and reconsideration of some of the compensation and benefits packages and programs already in place. But here’s the rub. It is precisely in this tough economic period that executive leaders should be enriched by competitive pay and benefits. How else can companies regain revenues, stability and profits if not with better leadership? Fortunately, enough companies see opportunity in this dilemma. As a result, benefit specialists are working hard to refine and optimize total reward programs. Ultimately, it is about what is cost effective to all shareholders.
Changing Gears With the major issue of stock option expense resolved, and demand for alignment of shareholder and executive interests at the forefront, executive benefits may well be the next cost efficiency option to improving shareholder value. In determining the suitability of benefits—based on corporate philosophy, need and shareholder value—we first need to view compensation and benefits as an integrated and cohesive whole. That requires bringing a strategic mindset to the process. This process (Chart B) begins with clear understanding of the company mission, values and desired results. Then, it is time to dig deep into the numbers to create solutions that match your company’s objectives and strategic direction. Due to internal and external influences, look beyond compensation to executive benefits for the integrated solution. Chart B
The Integrated Whole Most compensation and benefit programs are designed and structured to meet a given company’s business purpose. Few companies, however, designed them to work in concert with an overall business strategy. For example, if the primary strategic goal is to grow market share against the lead competitor, then set the metrics to drive executives to that goal and reward them when they do. The total rewards strategy must support the overall business strategy. An integrated executive benefit strategy 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, restricted stock awards and long-term incentives.
Nonqualified Deferred Compensation (NQDC) Deferred compensation is at the core of executive benefits, and is one of the most effective ways to align the interest of executives with those of shareholders. From the corporate standpoint, when you defer compensation, you do not weaken or dilute ownership. And, deferred compensation is not an expensive proposition. In part, they are so prevalent because of negligible cost due to the use of various funding vehicles. You simply give your executives the choice to defer (or not) their own compensation into tax-advantaged accumulation accounts. The distribution of these deferred dollars must be planned out to meet their cash needs for life events, such as college expense for children (Chart C). These accounts are comprised of the same compensation dollars that otherwise would have been paid in salary or bonus. However, these accounts function like a tax-deferred cash management account to help an executive with tax planning, as well as handling life events. Normally, the executive would have the ability to manage a mutual fund-type of portfolio in these tax deferred accounts. Chart C Participant Age 40 – 2 Children, Ages 13 & 11
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. From the company perspective, these arrangements are designed as nonqualified and, as such, allow you to offer the plan to only highly compensated employees. For many companies, the primary objective of these programs is to provide an additional vehicle to facilitate wealth accumulation, tax-advantaged and portfolio management opportunities. The ability to compound unlimited amounts of compensation (no IRS limits) in a tax-deferred environment is an extremely attractive benefit for your senior executive team (Chart D), and personally difficult for the executive to achieve without such as plan. Additionally, a NQDC plan can serve as a parking place for signing bonuses with “golden handcuff” vesting requirements. These plans are also being used to help executives defer the tax on restricted stock units and to help them meet company mandated stock ownership requirements on a pre-tax basis. A company may use this plan as a retention tool by offering a company match that vests years in the future. Because nonqualified plans are not subject to the IRS limitations or funding and reporting requirements, they breathe oxygen into your total rewards program. 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) 29% blended tax rate for Taxable Savings
Excess Benefit Plans You may wish to consider the two types of excess benefit plans for your overall strategy. Both restore lost qualified retirement benefits due to legislative limits. Excess benefit plans, like a deferred compensation plan, are nonqualified; that is, they are exempt from the filing, reporting, funding, and fiduciary requirements of ERISA (Employee Retirement Income Security Act), and companies are free to identify select individuals to be eligible for these arrangements. 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 2008, the defined benefit plan limit is $185,000 (IRC §415(b)). The defined contribution plan limit is $46,000 (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 excess benefit plan restores benefits that are withheld due to compensation limits (IRC §401(a)(17)) imposed on qualified defined benefit and defined contribution plans. In 2008 the compensation limit under this section is $230,000. 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 a different definition of compensation, one that may include annual incentives on other compensation for example. 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. 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. Better still, 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 Integral to sound financial and estate planning is the use of life insurance programs to provide income replacement for executives. They are used commonly 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; that is, one and a half [1.5] times the salary with a cap of $200,000. As a result, companies that want to offer a total compensation package with emphasis on security and flexibility should consider providing supplemental life insurance protection as a multiple of total compensation for its top management. Typically, this protection would equal three to five times the total pay with no cap. These arrangements are low cost to the company, and provide a significant benefit to key employees. The company would simply provide this benefit on top of the existing group life insurance plan.
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; that is, 66 2/3 % of salary with a cap of $15,000. An executive with $500,000 of base salary and a $200,000 bonus opportunity is covered for only 26% of their total compensation. What’s more, based on the design of the company’s stock option plan, the executive may lose the benefit from any future gains. Most group disability programs also have the incorrect definitions of disability to cover an executive’s responsibilities. The definition usually states that disability is the “inability of the insured to perform any of the duties of their occupation.” This would be a problem, as most executives would attempt to perform some duties, even if it is on a conference call or sending e-mails. Most group disability policies would treat this as “partial disability”, and not pay the full benefit. Today, companies are designing supplemental plans to fill the void and base the benefits on total compensation, as well as the value of restricted stock and stock options. Again, for the value these plans add to an executive’s overall package, the cost is minimal and well returned to the company.
Perquisites Executive perks may be created in a multitude of ways. Access to corporate aircraft. As more responsibility for retirement planning begins to shift to executives themselves, certainly in terms of investment choices, financial counseling and financial planning services have become a highly valued executive benefit. To date, roughly one-third of companies polled in a 2007 Clark Consulting Executive Benefits survey currently provide some form of financial counseling to their executives. What of the other 66 percent of corporations? What do their executives do? Without prudent and comprehensive financial counseling services, an executive may face many unintended consequences. At worst, he or she may fail to meet retirement goals. By offering effective financial advisory services, you can focus the executive’s attention on the company’s mission and business because he will be secure in the knowledge that his own 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 one more nugget in a benefit-rich company-sponsored program.
The RCG Process After long experience in designing client-specific compensation and benefit programs, we have proof-positive that the following steps best support your total package, and blend compensation, benefits and perks into one solid foundation:
“First, do no harm” in our profession would translate as “First, do no shortcuts.” Without the strategic mindset to build a total rewards program, harm can come to employers who fall short of objectives, shareholders who face a shortfall in returns, and executives who are shortchanged in retirement.
Footnotes:
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,
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First, do no harm is a dictum thought to be part of Hippocratic Oath taken by physicians. While its origins are disputed, the concept behind is not. And, it is not a stretch to apply this dictum to the business of executive compensation and benefits. 
We’ve all declared at one time or another: “We want our people to think like owners.” 
The stock market has been upset for thirty-six months. Companies have implemented massive layoffs, hiring freezes, bonus cuts and, in many instances, long-term incentive payouts or major appreciation in stock options have all but disappeared. 
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: 1) provide an attractive recruitment tool; 2) reward for performance by linking to company performance goals; and, 3) serve as a retention tool.
Paid dues to a country club. Car and clothing allowances. In our view, financial counseling is one of the fastest growing and most valuable perks in a modern executive benefits program, and it has the potential to tie everything together.