VideoLike most companies, Boston Edison Co. likes to avoid unpleasant surprises. So last year, the utility chose to fund its nonqualifed deferred compensation plan with investments that mimic the securities in its established tax-sheltered 401(k) plan. The nonqualifed plan, a "top hat" designed to provide retirement benefits for senior managers, already had been fully funded for several years -- using corporate-owned life insurance, or COLI. But by setting up a new approach that tracks the 401(k)'s performance, "we now have the best program imaginable," declares Donald Anastasia, Boston Edison's assistant treasurer.
The Massachusetts utility is in good company. At hundreds of corporations around the United States, finance executives are reviewing their funding choices for those deferred compensation plans that don't meet Internal Revenue Service tax-exemption standards-- hoping to get balance-sheet protection for the programs that serve the retirement needs of employees paid more than the maximum salary the IRS allows. Between 65 and 70 percent of concerns with more than 5,000 employees have top hats, according to New Yorkbased Buck Consultants, specialists in deferred benefits planning. That's up from 55 to 60 percent five years ago.
For the most part, the pursuit of funding for such liabilities is a recent development. Until 1992, few companies bothered to arrange funding for their top hats at all. Instead, they managed retirement benefits for the upper ranks of management--which were generally paid out in a lump sum at the point of retirement-- on a pay-as-you-go basis. "As long as these liabilities were not so large as to be unmanageable, and the company was earning a more-than-average return on capital, then it made sense to finance the lump sums out of profits," says Gordon Gould, chief actuary at Towers Perrin, an HR management consulting firm. (About half the companies with nonqualified plans still forgo formal funding for them.)
As 1993 approached, however, pressure on big companies to arrange funding increased sharply. That year, Congress declared that employees earning more than $150,000 couldn't qualify for tax-sheltered 401(k) contributions. (The ceiling, which previously had been $235,840, has since been allowed to creep up to $160,000. Another boost in the ceiling, to $200,000, is now being considered.) With the ceiling set to be lowered, companies rushed to create or extend nonqualified plans--of either the defined- benefit or the defined-contribution variety -- and the number of participants in such plans grew exponentially. In 1992, new nonqualified- plan filings with the Labor Department surged from 1,842 to 6,619, and filings have topped 4,500 each year since.
While reliable statistics on top hats are rare -- the government doesn't compile such data--Buck Consultants estimates that about $3 billion is likely deferred each year, based on reasonable assumptions about how many employees companies make eligible. And with plans in place, companies have expanded them by including lower-paid executives as well. Indeed, in 1998, the Los Angelesbased compensation and benefits strategy firm Compensation Resource Group found that 53 percent of Fortune 1,000 companies offered nonqualified benefits to employees earning less than $100,000 a year.
As nonqualified-plan participants have increased, so also has the importance of the plans as a source of retirement income. "As much as 90 percent of a CEO's retirement income can come from a nonqualified plan," says Chris Rich, president of Lyons Compensation & Benefits LLC, a Waltham, Massachusetts-based benefits consulting group.
But it is the funding of the plans that has become a priority for finance departments of late. And there, CFOs have two major choices: setting up a trust containing a portfolio of investments, or tying benefits to COLI outside of any trust arrangement.
Blessings from a Rabbi Trust
Hewlett-Packard Co. has put a lot of work into its top-hat funding arrangements. For years, the huge Palo Alto, California-based computer maker chose the pay-as-you-go approach, and the liability associated with the plan was credited only at a rate of return linked to a fixed-income instrument. "But for the security of the benefits -- basically for the peace of mind of the executives whose assets are held in trust--we decided to purchase real assets in 1996," says Jean-Claude Gauthier, global benefits financing manager, who oversees the financing of HP's benefits programs around the world.
Gauthier, like the finance executives at many companies, chose something called a rabbi trust to help fund his company's top hat. Under a rabbi trust (so named because the first one was created by a rabbi who wanted to assure that his pension would be portable if he switched synagogues), the employer gets to set aside funds in an irrevocable grantor trust. The trusts are the most common funding structures for nonqualified plans, although trust assets cannot be insulated from general creditors in bankruptcy filings--the trade-off that makes the set-aside for executives acceptable to the government.
HP finances its rabbi-trust assets with an institutional index fund linked to the Standard & Poor's 500. The fund, purchased from The Vanguard Group, was chosen specifically because of its tax implications. With the fund's low turnover in assets, taxable capital gains are kept to a minimum. That's important, because tax issues plague nonqualified plans, even if they use rabbi trusts.
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