Changing the View on Secular Trusts

Benefit Security for the New Order of Business

William L MacDonald
Chairman, President & CEO
Retirement Capital Group, Inc

If you’ve ever run a red-light and been caught on camera, you know how it feels to not see what you see. Or the expression on your face when see the photo. Green, yellow, red. Click! What a blur. In life, as in an intersection, not seeing what’s in front of you can cost you.

As business uncertainties persist, and corporate liabilities rise, the safety of assets in nonqualified deferred compensation (NQDC) plans and Supplement Executive Retirement Plans (SERPs) grows urgent because companies didn’t see hazards ahead.

Thousands of companies and their executives have been sorely affected by today’s economic realities. To blunt losses, and protect remaining accumulations, management and boards are finding a new ally in a familiar icon: The Secular Trust. And the need is great. IRC Section 409A eliminated workable approaches to additional security including offshore trusts and haircut provisions.

Executive Risk

Four major events negatively affect an executive’s nonqualified benefits: 1) Change in control; 2) Change in the financial condition of their employer, short of insolvency; 3) Change of heart by management or the board; and, 4) Bankruptcy of the company. Chart I.

Chart I

Even More Risk

Most economists agree that tax rates will change in the future. However, few dare to predict when and how much. The likelihood that top federal income tax rates will increase in 2010 or 2011 seems probable, based on collective statements by the President and Congressional leaders. It is commonly expected that rates for higher income brackets will increase at or around $250,000 of taxable income. Already, a large share of executives are taking lump sum distributions due to concerns over benefit security with the unwelcomed consequence of pushing retirement distributions into the top tax bracket.

Take a glance at Chart II for a historical perspective on U.S. top income tax rates. We draw this conclusion: Wealth accumulation should not be dependent on a single asset or assumption. Many financial planners do preach diversification in contribution and accumulation vehicles. But not until recently did they begin to focus on the more problematic need to create diversification for an executive’s future distributions.

Chart II

The Three Phases of Your Money

To fully appreciate the value of a Secular Trust, and to better prepare for retirement planning, we need to examine closely the three phases or movements of money.

Contribution Phase
Simple enough, this is the phase when you make contributions to your various plans. The question is, “should you save pre-tax or after tax or both?” We have always been led to believe that a pre-tax investment is always better than an after-tax investment, but is that really true?

Take your investment in your personal residence, for example. Most of us purchased our home with after-tax dollars. When the home appreciated (the accumulation stage), it grew tax deferred. When we sold it (the distribution phase), we paid capital gains tax verses ordinary income. In fact, the government “gives” us a $500,000 exemption, if it is our primary residence.

Then, isn’t it really the accumulation phase and the distribution phase that make this investment a valuable one? Another good example is the Roth IRA. By making an after-tax contribution, however, the investment grows tax deferred, and the income is tax free.

Accumulation Phase
When designing any retirement strategy, the highest return on your investment is central to success. Most people follow modern portfolio theory and diversify their investment strategy, and why many invest in mutual funds. The objective in this phase is “tax-deferred accumulation,” or, at least, minimize your taxes during the accumulation.

Chart III shows how a $100,000 growing taxed deferred at 7 percent, versus being subject to tax on the accumulation at 40 percent and 28 percent. Deferring a portion or all of your taxes during this phase can make a significant difference.

Chart III

Distribution Phase
The final phase defines how you withdraw or distribute your money at retirement; ostensibly, the most important phase of your retirement planning. Of course, it is not how much you accumulate in these plans; it is how much you keep. By selecting the right vehicles, you minimize taxes on distribution.

True diversification offers varying distribution sources with varying tax treatments, as illustrated in Chart IV. Notice how an increase in the top tax rate from 35 to 50 percent reduces your distribution assumptions by roughly 25 percent per year in your taxable accounts. That’s why, it is important that a portion of the investment is allocated to a non-taxable bucket, designed to provide a hedge against future higher tax rates.. Again, this phase showcases new funding strategies for the Secular Trust.

Chart IV

Rethinking Secular Trusts

Historically, rabbi trusts have delivered a fairly reliable answer to the protection of retirement assets in NQDC plans. They insulate executives against a company’s refusal to pay out benefits in a change of control, change in financial condition or charge of heart situation. But the greatest risk of nonpayment arises out of a company’s insolvency.

Indeed, few, if any, of the conventional approaches to benefit security are completely satisfactory because the potential for breech exists. In our opinion, the ideal arrangement ensures payment of benefits whether a company is unwilling or unable to pay, including its insolvency.

Often overlooked, secular trusts actually accomplish security in a highly cost-effective manner. Chart V presents a snapshot of the caliber of companies applying the secular trust. Secular trusts are used today to fund excess benefit plans, deferred compensation arrangements and SERPs where benefit security is a concern. In fact, though use is limited at this point, it is still on the rise. According to an executive benefit survey conducted by Clark Consulting in 2007, 7 percent of a Fortune 1000 sampling had implemented a secular trust, up from 5 percent in 2005. In RCG’s own research, we saw a distinct increase in 2008 and 2009, and predict the growth will continue.

Executives familiar with secular trusts typically viewed the security aspect favorably; however, they also believed after-tax investment doesn’t make sense economically. That was then; this is now. Today, secular trusts are funded differently. And this new approach to funding has transformed the secular trust into a very attractive solution, compared to pre-tax deferred compensation arrangements, for many companies. See Chart V below.

Chart V

Secular Trusts vs. Rabbi Trusts

Secular trusts are named to distinguish them from Rabbi trusts . Importantly, an employer’s creditors cannot reach the money held in a secular trust (Chart VI).

Chart VI

Funding with Full Protection

Secular trusts are established by an employer specifically for the purpose of providing NQDC plans with full protection against the claims of creditors. Thus, a secular trust constitutes a “funding” of a NQDC arrangement, such that vested amounts are included in executive income and amounts are not tax-deferred. It is the absence of the risk of employer bankruptcy, or what the IRS calls lack of substantial risk of forfeiture, that causes the secular trust to become an after-tax approach. In the past, the economics of an after-tax investment made secular trusts somewhat unattractive; however, new funding vehicles and approaches have reversed that thinking.

Types of Secular Trusts

Generally, there are two types of secular trusts. The first is referred to as an Employer Secular Trust. The second type is the Employee Grantor Trust. Both arrangements are irrevocable, which means that once assets vest in the trust, they are outside the reach of creditors and off the balance sheet of the company as a liability. Let’s drill down deeper on these types:

Employer Secular Trust
Under this structure, the employer contributes assets to the trust, which is considered a taxable payment to the employee. The Employer Secular Trust is also considered a separate taxable entity, separate from the company, and files its own tax return.

Any trust earnings will generally be taxed twice, once to the trust, and again to the employee. The double taxation comes first at the trust level, and then again on the same earnings to the employee. But, the double taxation can be avoided if the trust pays out any earnings in the year earned. In short, the Employer Secular Trust taxes company contributions to employees, then to the trust, as they vest, and then the earnings on the trust assets to the employee.

Employee Grantor Trust
Established by the employee, these trusts are deemed owned by the employee, who is the grantor. As a result, Employee Grantor Trust income is taxable to the employee only. Since there is no separate tax-paying trust like the Employer Secular, you avoid the double taxation. The employer still funds the trust with tax-deductible contributions; however, technically, employer payments are offered first to each plan participant, who in turn authorizes payment directly to the trust. This requirement, known as a Crummy style power (IRC Section 678, IRS letter ruling 9316008), helps to satisfy this structure by giving employees a certain period of time (typically 30 days) to decide whether to have the employer contribute such amounts to the trust or pay the amounts to the employee as current cash compensation.

For those of you that have done estate planning using an irrevocable insurance trust, this is exactly like that Crummy provision in your trust. Most organizations are now adopting the Employee Secular Trust to avoid the double taxation.

Funding of the Secular Trust

With all the advantages of the secular trust, you would expect all companies offering NQDC benefits to adopt one. As cited earlier, the economics of investing after-tax dollars has been the obstacle. Chart VII illustrates a comparison of the old economics. We use a 50-year old executive with annual contributions of $50,000 to a traditional pre-tax deferral plan verses an after-tax contribution of $30,000 over the same period (15 years).

As you can see, even in a lower assumed tax bracket on the secular trust, the executive is 16.53 percent better off with the pre-tax plan, assuming tax rates stay the same. As a reminder, the executive is subject to the company creditors, and he has less flexibility under §409A .

Chart VII

Today, plan sponsors and participants use more advantaged funding strategies in Employee Grantor Secular Trusts to minimize the taxes during the accumulation period, assets like exchange-traded funds (ETF), tax-advantaged mutual funds, tax exempt bonds, annuities and life insurance.

What’s more, a major design feature of taking distributions “in-kind” allows the executive to choose when to liquidate the transferred assets and, therefore, when to be taxed on unrealized gains attributable to the assets. The $40,374 projected capital gains in Chart VII can be delayed. You can see in Chart VIII the economic benefits of an in-kind distribution. This one planning concept closed the gap and provided more flexibility and more benefit security.

Chart VIII

The above illustrations do not take into account the benefits of capital losses on the executive’s personal income tax, as we projected a 7 percent gain going forward.

Chart IX below gives us a look-back, and assumes the executive invested in the S&P 500 beginning in 1999. In this scenario, we carried the asset slightly over 10 years until retirement. Clearly, without the benefits of the loss on his personal return, he would have been better served by the secular versus a traditional deferred compensation plan with a lump sum at retirement ($62,122 annual income vs. $60,177).

The critical point: When you control the assets in a secular trust, without the restrictions of §409A, you can control your taxes.

Chart IX

To Adopt or Not

When first considering the adoption of a secular trust, two fundamental questions emerge:

Why would a company want to establish a secular trust instead of paying an executive cash compensation for him to invest?
First, the company may wish to provide retirement benefits (SERP or Excess Plan) for an executive, but has serious concern if the executive will save the money for retirement. The company may also provide minimal incentives to encourage the executive to remain employed until retirement (adding vesting or clawbacks). Further, some employers provide “tax gross up” incentives to pay the tax, either on the investment earnings or contributions, to enhance the benefits. Finally, by virtue of its own sponsorship, the company may gain multiple advantages in a better selection of asset classes, lower asset fees, and added investment counseling.
Would an executive object to paying tax currently on money that will not be paid to him or her until retirement?
The executive may indeed object to current taxation for deferred compensation — except that the employer is withholding tax today (depositing after tax amounts) which exposes the executive’s growth to capital gains income (which should be lower).

Optimizing the Economics

A variety of ways exist to improve the economics on the after-tax contributions. Companies mitigate the perceived negatives of after-tax investing in a secular trust, and simulate pre-tax compounding by building these design features into their NQDC plans:

Employer gross ups – additional employer contributions to the trust in the amount of the tax; guards against shareholder concerns and bad proxy statement optics.
Additional employer contributions in the amount of the earnings on the tax portion of the contribution – additional contributions to restore lost earnings. Employers may consider installing a cap on the amount of such earnings (7 percent); however, again, guard against shareholder and proxy optic concerns.
One innovative approach in play today is a life insurance structure specifically designed to optimize economics—one with a “tax restoration” non-recourse loan from the insurer in the amount of the loan. In this case, the executive elects to restore the loan without a cost to the company. The tax restoration feature allows the executive to emulate the pre-tax accumulation; therefore, he or she is deferring the impact of the taxes. See Chart X.

This approach also allows the executive to withdraw cash on a non-taxable basis, mitigating the risk of future tax hikes.

The insurance product offers more than 60 investments with leading fund managers, and helps the executive in the accumulation phase by growing investments tax deferred on the pre-tax amount due to the loan. The executive then takes a distribution during the distribution phase on a non-taxable basis for both premium payments and investment earnings. The insurance company is paid back for the tax restoration loan and interest with a portion of the life insurance benefits.

Chart X

Let’s work with an example: Consider the contribution level of $50,000 pre-tax or $30,000 after tax illustrated in Chart VII. Now, look at the Chart XI below which illustrates the three alternatives outlined above. Notice how the tax gross-up is the most expensive. In today’s environment, it is less prevalent. But the life insurance option with the tax restoration feature carries no company cost. Better still, the executive can elect to emulate the pre-tax contribution during his accumulation phase, which produces a comparable benefit to a pre-tax strategy, with all income distributed on a non-taxable basis.

Chart XI

Creating a Retention Tool

Admittedly, most traditional designs of a secular trust do not deliver the executive retention benefit to the company provided by a “golden handcuffs” or the “glue-in-the-seat” plan option. Once contributions are made and vested, the company has no access to those funds. Creative thinking on the design side is changing that outcome.

One way to secure the plan retention effect, while allowing for accumulation of recognized executive income, is to keep the plan’s vesting provisions intact, as outlined under Rev. Ruling 2007-48. An executive can also be encouraged to make a Sec 83(b) election, similar to receiving restricted stock, or place a clawback feature that may be tied to a restrictive covenant.

Impact Revenue Ruling 2007-48

Rev. Rul. 2007-48 provides clear guidelines for setting up an Employer Secular Trust arrangement in which benefits vest over time according to the employer’s plan. The IRS has not specifically approved of a vesting structure in an Employee Grantor Trust as of this writing.

Rev. Rul. 2007-48 stipulates that a beneficiary of an Employer Secular Trust incurs no taxable income on account of his or her interest in the trust until the participant’s benefits vest. And, as long as the trust maintains separate accounts for each participant, the employer may deduct its contributions in the taxable year in which amounts attributable to such contributions become vested — even if such amounts are not actually paid out.

Clawback vs. §83(b) Election

A clawback describes a situation when participants in the plan are required to pay benefit distributions back to the plan upon the occurrence of certain events, typically within the participant’s control. Its use, under a plan funded through a secular trust, may be permissible depending on facts, circumstances, and applicable state law.

In determining the enforceability of a clawback, and depending on which type, it may not be necessary to retain the plan’s vesting features under Rev. Rul. 2007-48. The use of a §83(b) election, however, is also available with an Employer Secular Trust; the law is clearer in this area. Under §83(b), an employee that receives a “transfer of property” from an employer in connection with the performance of services may elect to include in income — for the taxable year in which the transfer occurs — the fair market value of the property at the time of transfer; that is,where the property remains unvested and subject to a substantial risk of forfeiture.

Section 83(b) elections can be used to make unvested contributions to a secular trust includible in an employee’s gross income and deductible by the employer in the year of the contribution rather than the year of vesting or payment.

Note: For more information regarding §86(b) Election, please visit http://www.fairmark.com/execcomp/sec83b.htm.

Challenges of §83(b) Election

At this point, we should define “transfer.” Under §83(b), a transfer occurs when the employee acquires an ownership interest in property (disregarding the existence of a substantial risk of forfeiture or vesting condition). The IRS has issued guidance indicating that the term “transfer” includes a transfer of something less than complete ownership to the employee.

The §83(b) regulations also clarify the term “property” to include a beneficial interest in assets (including money) transferred or set aside from the claims of creditors of the employer, for example, in a secular trust. A potential drawback to the §83(b) election compared to a clawback involves the tax treatment upon a later forfeiture of the payments.

If an employee makes a §83(b) election, but the payments are forfeited in a later tax year, the forfeiture is generally treated as a loss to the employee due to a sale or exchange of property; that is, the employee is not able to deduct the loss in the subsequent tax year. For the employer, however, the reversion of the forfeited amount constitutes a “recovery” of a prior deduction and produces taxable income. On the other hand, a clawback generally results in the employee’s ability to claim a deduction. If the employee is unable to reverse the prior recognition of income, the employer does not lose its deduction.

Timing is Paramount

Another potential problem: Despite an §83(b) election, the obligation to pay and withhold for employment (FICA and FUTA) taxes does not arise until the payments are vested (when values could be substantially higher). In a secular trust, that means the year of the employer contribution, even though payments are includible in the employee’s taxable income, and deductible by the employer, in that year. The IRS has made it clear that rules governing the payment of employment taxes look to the time at which the payment is actually or constructively made. With a clawback, the obligation to pay and withhold for employment taxes occurs at the time of the original payment.

IRS guidance on timing of income tax withholding by the employer, where an employee makes a §83(b) election, is less clear. The guidance appears to provide that the obligation to withhold for income taxes does not arise until vesting. Given that the employer’s income tax withholding obligation does not affect the actual amount of income taxes payable by the employee (unlike employment tax withholding), this is probably not a significant concern.

PPA Limits on Secular Trusts

A final and relevant consideration, depending on employer circumstances, is legal changes arising out of the Pension Protection Act of 2006. The PPA included a revision to §409A limiting certain corporate actions such asdistributions during a “restricted period” if a plan sponsor’s defined benefit pension plan is “at risk.”

Section 409A(b)(3) could prohibit a public company that has an “at risk” pension plan anywhere within its controlled group from making contributions to a secular trust (or otherwise setting aside funds) for non-qualified plan benefits. It appears, however, that an affected employer could still pay non-qualified plan benefits directly from its general assets. These “at risk” rules became effective January 1, 2008. Given the current economic climate, many pension plans may have become “at risk” during 2008 or 2009, causing these funding restrictions to apply in 2009 and beyond.

Changing the View

If you rotate a prism in bright light, the most pleasing color spectrum appears. With each rotation, you see something new and different by changing of view. Apply that principle to the secular trust, a long-held icon of benefit security, and you will discover design features and funding vehicles with new brilliance to help executives diversify distributions and appreciate greater security and flexibility in retirement.

Securities are offered by Retirement Capital Group Securities, Member FINRA / SiPC. Retirement Capital Group Securities, Inc. is a wholly owned subsidiary of Retirement Capital Group, Inc.

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William L. MacDonald, Registered Representative - California Insurance License #0556980